Economics, Global Edition, 13th edition Michael Parkin Solution Manual

Economics, Global Edition, 13th edition By Michael Parkin

Email: Richard@qwconsultancy.com

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WHAT IS ECONOMICS?

The Big Picture Where we are going: After completing Chapter 1, the student will have a good sense for the range of questions that economics addresses and will be on the path towards an economic way of thinking. The students will begin to think of cost as a forgone alternative—an opportunity cost—and also about making choices by balancing marginal costs and marginal benefits.

Chapter 2 reinforces the central themes of Chapter 1 by laying out a core economic model, the production possibilities frontier (PPF), and using it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 also provides a deeper explanation, again with a model, of the concepts of marginal cost and marginal benefit, beginning with the concept of efficiency, and concluding with a review of the source of the gains from specialization and exchange.

New in the Thirteenth Edition A significant change to this chapter that you probably want to spend some time on is a new section that presents data about the economics major and how well it ranks in the income spectrum of all majors. Most of the other content of this chapter remains the same short of updates to date sensitive items. There a minor reworking in the beginning of the math appendix that added clarity to the topics discussed.

This important chapter is not one to gloss over as it lays down an important foundation that can be drawn from as you move through more specific applications later. Students relate well to the section on self and social interest which calls out issues of both efficiency and fairness and is great for class discussion. Economics in the News covers some current issues with Facebook and Mark Zuckerberg’s vision to have the Internet available to the whole world.

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Lecture Notes

What Is Economics?

I.

Definition of Economics • •

Economic questions arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants.

Scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.

Forbes lists Bill Gates and Warren Buffet among some of the wealthiest Americans. Do these two men face scarcity? According to The Wall Street Journal, both men are ardent bridge players, yet they have never won one of the many national bridge tournaments they have entered as a team. These two men can easily afford the best bridge coaches in the world and but other duties keep them from practicing as much as they would need to in order to win. So even the wealthiest two Americans face scarcity (of time) and must choose how to spend their time.

Economics • • •

Economics is the social science that studies the choices that individuals, businesses, governments and entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices.

Economists work to understand when the pursuit of self-interest advances the social interest Economics is divided into microeconomics and macroeconomics: • Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments.

• Macroeconomics is the study of the performance of the national economy and the global economy.

On the first day do a “pop quiz.” Have your students write on paper the answer to “What is Economics?”

Reassure them that this is their opinion since it is the first day. You will find most of the answers focused around money and/or business. Stress that Economics is a social science, a study of human behavior given the scarcity problem. All too often first-time students (especially business students) think that Economics is just about making money. Certainly, the discipline can and does outline reasons why workers work longer hours to increase their wage earnings, or why firms seek profit as their incentive. But Economics also explains why a terminally ill cancer patient might opt for pain medication as opposed to continued chemotherapy/radiation, or why someone no longer in the workforce wants to go to college and attain a Bachelor’s degree, in their sheer pleasure of learning and understanding. Stressing the social part of our science now will help later when relating details to the overall bigger picture (especially when time later in the semester seems scarce, no pun intended!).

The definition in the text: “Economics is the social science that studies the choices that individuals, businesses, governments, and societies make as they cope with scarcity and the incentives that influence and reconcile these choices,” is a modern language version of Lionel Robbins famous definition, “Economics is the science which studies human behavior as a relationship between ends and scarce means that have alternative uses.”

Other definitions include those of Keynes and Marshall: John Maynard Keynes: “The theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps it possessors to draw correct conclusions.” .

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Alfred Marshall: “Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.”

A “shorthand” definition that resonates with students is: “Economics is the study of trying to satisfy unlimited wants with limited resources.” Students can—and do—easily abbreviate this definition to “unlimited wants and limited resources,” which captures an essential economic insight.

II. Two Big Economic Questions How do choices wind up determining what, how, and for whom goods and services are produced?

What, How and For Whom?

• •

• •

Goods and services are the objects that people value and produce to satisfy human wants. What we produce changes over time—today we produce more MP3s and CDs than 5 years ago.

Goods and services are produced using the productive resources called factors of production.

These are land (the “gifts of nature”, natural resources), labor (the work time and work effort people devote to production), capital (the tools, instruments, machines, buildings, and other constructions now used to produce goods and services), and entrepreneurship (the human resource that organizes labor, land, and capital).

The quality of labor depends on human capital, which is the knowledge and skill that people obtain from education, work experience, and on-the-job training.

Owners of the factors of production earn income by selling the services of their factors. Land earns rent, labor earns wages, capital earns interest, and entrepreneurship earns profit.

Do Choices Made in the Pursuit of Self-Interest also promote the social interest?

• • •

You make a choice in your self-interest if you think that choice is the best one available for you.

An outcome is in the social interest if it is best for society as a whole.

A major question economists explore is “Could it be possible that when each of us makes choices in our self-interest, these choices are in the social interest?’

The Two Big Economic Questions Don’t skip the questions in a rush to get to the economic way of thinking. Open your students’ eyes to economic in the world around them. Ask them to bring a newspaper to class and to identify headlines that deal with stories about What, How, and For Whom. Use Economics in the News Today on your Parkin Web site for a current news item and for an archive of past items (with questions). Pose questions but hold off on the answers letting them know that “we can have a much more fruitful discussion when our toolbox is full.” Remind them that this course is about learning simple economic models that provide tools to seek answers to complex issues.

Students (and others!) often take the answers to the what, how, and for whom questions for granted. For instance, most of the time we do not bother to wonder “How does our economy determine how many light bulbs, automobiles, and pizzas to produce?” (what), or “Why does harvesting wheat from a plot of land in India occur with hundreds of laborers toiling with oxen pulling threshing machines, while in the United States, a single farmer listening to a Garth Brooks CD and sitting in an air-conditioned cab of a $500,000 machine harvests the same quantity of wheat from the same sized plot of land?” (how), or “Why is the annual income of an inspiring and effective grade school teacher much less than that of an average majorleague baseball player?” (for whom). Explaining the answers to these types of questions and determining whether the answers are in the social interest is a major part of microeconomics.

Figure 1.1 in the textbook “What Three Countries Produce” ties in nicely with Chapter 2’s later discussion on the PPF. Figure 1.1 also links the three questions of what, how and for whom nicely to the component .

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parts of those questions: goods and services, factors of production (land, labor, capital, entrepreneurship), and incomes economic agents earn (rent, wages, interest and profit).

•

We can examine whether the self-interested choices serve the social interest for a variety topics: • Globalization: Buying an iPod allows workers overseas to earn a wage and provide for family • Information-Age Monopolies: A firm producing popular software leads to format standards • Climate Change: Carbon dioxide emissions led to higher global temperatures and climate change • Financial Instability: Bank bailouts with the intent of social interest may cause more risky loans to be made in the future by banks serving their own self-interests.

III. Economic Way of Thinking

Scarcity requires choices and choices create tradeoffs.

What is the difference between scarcity and poverty?

Ask the students why they haven’t yet attained all of their personal goals. One reason will be that they lack sufficient money. Ask them if they could attain all of their goals if they were as rich as Bill Gates. They quickly realize that time is a big constraint—and the great leveler: we all have only 24 hours in a day. They have stumbled on the fact that scarcity, which even Bill Gates faces, is not poverty.

A Choice is a Tradeoff • •

A tradeoff is an exchange—giving up one thing to get another.

Whatever choice you make, you could have chosen something else.

Virtually every choice that can be thought of involves a tradeoff. Presenting a few of the following as examples can help your class better appreciate this key point: • Consumption and savings: If someone decides to save more of his or her income, savings can be funneled through the financial system to finance businesses new capital purchases. As a society, we trade off current consumption for economic growth and higher future consumption.

• Education and training: A student remaining in school for another two years to complete a degree will need to forgo a significant amount of leisure time. But by doing so, he or she will be better educated and will be more productive. As a society, we trade off current production for greater future production.

• Research and development: Factory automation brings greater productivity in the future, but means smaller current production. As a society, we trade off current production for greater future production.

Making a Rational Choice • •

A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice.

But how do people choose rationally? Why do more people choose an iPhone rather than a Windows phone? Why has the U.S. government chosen to build an interstate highway system and not an interstate high-speed railroad system? The answers turn on comparing benefits and costs.

Benefit: What you Gain • •

The benefit of something is the gain or pleasure that it brings and is determined by preferences— by what a person likes and dislikes and the intensity of those feelings.

Some benefits are large and easy to identify, such as the benefit that you get from being in school.

Much of that benefit is the additional goods and services that you will be able to enjoy with the boost to your earning power when you graduate. .

WHAT IS ECONOMICS?

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Some benefits are small, such as the benefit you get from a slice of pizza. That benefit is just the pleasure and nutrition that you get from your pizza.

Cost: What You Must Give Up

Seeing choices as tradeoffs shows there is an opportunity cost of a choice. The opportunity cost of something is the highest-valued alternative that must be given up to get it. So, for instance, the opportunity cost of being in school is all the good things that you can’t afford and don’t have the spare time to enjoy.

Students like the “Dr. Suess Version”: Opportunity cost is the thing you would have done if you did not do what you did.

What is the Opportunity Cost of Getting a College Degree?

When the students calculate their opportunity cost of being in school, be sure they place a value on their leisure time lost to studying on weekends and evenings. Most students are shaken when they realize that when lost leisure time and income is included in their calculations, the opportunity cost of a college degree approaches $200,000 or more. Don’t leave them hanging here though. Mention that a college education does yield a high rate of financial return over.

To ensure that people do not die of any serious side effects, the Food and Drug Administration (FDA) requires all drug companies to thoroughly test newly developed medicines before allowing them to be sold in the United States. However, it takes many years to perform these tests and many people suffering from the terminal diseases these new medicines are designed to cure will die before good new medicines are eventually approved for use. Yet, if the FDA were to abandon this testing process, many others would die from the serious side effects of those bad medicines that made it to market. People’s lives will be at risk under either policy alternative. This stark example of a tradeoff reveals the idea that choices have opportunity costs.

How Much? Choosing at the Margin •

• •

Making choices at the margin means looking at the trade-offs that arise from making small changes in an activity. People make choices at the margin by comparing the benefit from a small change in an activity (which is the marginal benefit) to the cost of making a small change in an activity (which is the marginal cost).

Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change.

For example, if homework assignments are weighed more heavily in a class’s final grade, the marginal benefit of completing homework assignments has increased and more students will do the homework.

Choices Respond to Incentives • •

Economists take human nature as given and view people acting in their self-interest.

Self-interest actions are not necessarily selfish actions.

Self interest can be said to be in the eye of the beholder. Thus, covering the next portion on positive versus normative analysis can be crucial to the student’s understanding how economic agents act in their own self-interests, but perhaps not (and often not) in other’s self-interest.

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IV. Economics as Social Science and Policy Tool Economist as Social Scientist •

• •

•

Economists distinguish between positive statements and normative statements. A positive statement is about “what is” and is testable. A normative statement is about “what ought to be” and is an opinion and so is inherently not testable. A positive statement is “Raising the tax on a gallon of gasoline will raise the price of gasoline and lead more people to buy smaller cars” while a normative statement is “The tax on a gallon of gasoline should be raised.”

Economists tend to agree on positive statements, though they might disagree on normative statements.

An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Economic models describe the economic world in the same way that a road map explains the road system: Both focus on only what is important and both are abstract depictions of the real world.

Testing an economic model can be difficult, given we observe the outcomes of the simultaneous operation of many factors. So, economists use the following to copy with the problem: • Natural experiment: A situation that arises in the ordinary course of economic life in which the one factor of interest is different and other things are equal or similar.

• Statistical Investigation: A statistical investigation might look for the correlation of two variables, to see if there is some tendency for the two variables to move in a predictable and related way (e.g. cigarette smoking and lung cancer).

• Economic Experiment: Putting people in a decision-making situation and varying the influence of one factor at a time to see how they respond.

Economic Model vs. the General Lee Car Model When I was a kid, I had a plastic model car that I put together that was from Dukes of Hazard television show (you can insert your own “model” as you’d like). Tell the students, “Even though we all know the model car is not a “real” car, it does give us insights into what the real car is like. You have number on the door, the confederate flag on top, the proportions are correct and if you lift the little hood you can see what a V8 engine looks like”. An economic model is similar in that it gives us a glimpse of reality under some certain assumptions and although it is not reality it gives us insights about reality.

Economist as Policy Adviser • •

Economics is useful. It is a toolkit for advising governments and businesses and for making personal decisions.

For a given goal, economics provides a method of evaluating alternative solutions— comparing marginal benefits and marginal costs and finding the solution that makes the best use of the available resources.

The success of a model is judged by its ability to predict. Help your student’s appreciate that no matter how appealing or “realistic looking” a model appears to be, it is useless if it fails to predict. And the converse, no matter how abstract or far removed from reality a model appears to be, if it predicts well, it is valuable.

Milton Friedman’s Pool Hall example illustrates the point nicely. Imagine a physicist’s model that predicts where a carefully placed shot of a pool shark would go as he tries to sink the eight ball into the corner pocket. The model would be a complex, trigonometric equation involving a plethora of Greek symbols that no ordinary person would even recognize as representing a pool shot. It certainly wouldn’t depict what we actually see—a pool stick striking a pool cue on a rectangular patch of green felt. It wouldn’t even reflect the thought processes of the pool shark that relies on years of experience and the right “touch.” Yet, constructed correctly, this mathematical model would predict exactly where the cue ball .

WHAT IS ECONOMICS?

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would strike the eight ball, hit opposite the bank, and fall into the corner pocket. (You can easily invent analogous examples from any sport.)

V. Economists in the Economy Jobs for an Economics Major • • •

Economists work for private firms, governments, and international organizations. Some have a bachelor’s degree, while others have a master’s degree or a PhD. On their jobs, economists often collect and analyze data on production and use of resources, goods, and services in order to predict future trends or devise ways to use resources more efficiently.

Economists have jobs as market research analysts, financial analysts, and, less often, budget analysts. There were about 850,000 of these jobs in the United States in 2014.

Will Jobs for Economics Majors Grow?

•

The Bureau of Labor Statistics (BLS) has forecast that from 2014 to 2024, jobs for PhD economists will grow 6 percent; jobs for budget analysts will grow by only 2 percent; but jobs for financial analysts will grow by 12 percent; and jobs for market research analysts will grow by 19 percent.

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Additional Problems 1.

You plan a major adventure trip for the summer. You won’t be able to take your usual summer job that pays $6,000, and you won’t be able to live at home for free. The cost of your travel accomodations on the trip will be $3,000, gasoline will cost you $200, and your food will cost $1,400. What is the opportunity cost of taking this trip?

2.

The university has built a new parking garage. There is always an available parking spot, but it costs $1 per day. Before the new garage was built, it usually took 15 minutes of cruising to find a parking space. Compare the opportunity cost of parking in the new garage with that in the old parking lot. Which is less costly and by how much?

Solutions to Additional Problems 1.

The opportunity cost of taking this trip is $10,600. The opportunity cost of taking the trip is the highest-valued activity that you will give up so that you can go on the trip. In taking the trip, you will forgo all the goods and services that you could have bought with the income from your summer job ($6,000) plus the expenditure on travel accommodations ($3,000), gasoline ($200), and food ($1,400).

2.

The opportunity cost of parking before the building of the new parking garage is the highest-valued activity that you forgo by spending 15 minutes parking your car. The opportunity cost of parking in the new parking garage is $1 that you could have spent elsewhere. If the opportunity cost of 15 minutes spent parking your car is greater than the opportunity cost of $1, then the new parking garage is less costly.

Additional Discussion Questions 1.

Why are economists so concerned about the material aspects of life? Explain that this is a myth! Economists are often criticized for focusing on material well-being because of the general public’s view that economics is about money. Explain that there are economists that research social and emotional (or spiritual) aspects of life. You may also add that these parts of life often depend heavily on attaining material well-being. You may want to reference the Economic Freedom Index (www.freetheworld.com) and its explanatory power on issues of world hunger and poverty. Ask them to consider the need for lifeenhancing goods and services such as health care or education to support spiritual or emotional well-being. Ask how protestors would be able to voice their opinions without low-cost air travel and the power of the Internet to coordinate the activities of hundreds of protesters. (Be careful not to seem to be either condoning or condemning these activities.)

Most students will begin to see that the more efficient we are at producing material prosperity, the more time and opportunity everyone has to promote emotional (or spiritual) goals.

2.

Mini Case Study Illustrating How Economists Use Modeling: Women are unfairly underpaid when compared to men. Ask your students whether this statement is positive or normative. Mention that the media frequently reports that the average woman gets paid only 3/4 the wages of the average man. Is this “fact” a sufficient test of the positive statement?

If women were paid more than men in one or two professions (like professional modeling or elementary teaching) is that sufficient evidence to conclude that women in .

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general are not underpaid when compared to men? Ask the students to think about how to properly test the model. Are these counter examples enough to discard the idea that women are underpaid?

What would you take into account when you collected data to compare women’s salaries versus men’s salaries? Remind the students that any model directly comparing men’s and women’s wages should control for any differences in wage-relevant characteristics between working men and women. You can discuss many different reasons why a gender wage gap can occur, including: • Women are underrepresented in higher paid occupations and are overrepresented in lower paid occupations (the problem may not be unequal pay but instead it may be unequal access to high paying jobs (glass ceiling?); • Women are underrepresented among those earning advanced degrees, though mostly among older age cohorts (U.S. Bureau of Labor Statistics, Employment and Earnings, Vol. 45, January, 1998). Here the problem here might not be unequal pay but unequal access to higher education; • Women have relatively less occupational-specific work experience and have relatively less unbroken work experience, as many women struggle between pursuing a career and raising a family. For example, one study found that women who were not mothers earned 90 percent of men’s salaries, whereas those who were mothers earned only 77 percent (Waldfogel, “Understanding the ‘Family Gap’ in Pay for Women with Children,” Journal of Economic Perspectives, Vol. 12, No. 1, 1998).

Does it further the public interest (and the interests of women workers specifically) to propagate normative statements about wage inequality based on statistics without taking account of all relevant factors? Summarize the discussion by noting that economic studies have indeed found evidence that a gender gap in wages exists in the United States, even after controlling for all known relevant factors. However, the gender wage gap is much less than the 1/3 number often quoted by the media, and has been decreasing significantly over the last few decades (Blau, “Trends in the Well Being of American Women, 19701995,” Journal of Economic Literature, Vol. 36, No.1, March 1998). Get the students to see how properly applying the science of economics to social issues helps us strip away inflammatory rhetoric and examine the problem carefully and objectively.

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Chapter 1 Appendix, Graphs in Economics Lecture Notes Goggle Theory Explain to students that you are going to ask them to use three sets of goggles to view math in the course. I have found this to be a great tool for students to understand why we present data in different ways.

1. Equation Goggles: Write an equation in slope-intercept form and explain that this is one way to show relationships between two variables. I like to use X and Y for this one and then quickly explain that economics is much more fun than math because we may be talking about X-rays and Yo-Yo’s. This helps some students break the barrier early on what “variable” means.

2. Graphing Goggles: Work through a graph of the equation you wrote highlighting slope and intercept.

Indicate that this may be a Demand or Supply curve for instance.

3. Now you can explain that they will see all three of these forms of math at different times during the course and it is important for them to understand that you can move between all three anytime. We usually have it shown just one way for convenience. It is also fun during lecture to say, “I need you to pull out your graphing goggles.”

I.

Graphing Data • • •

Graphs are valuable tools that clarify what otherwise might be obscure relationships.

Graphs represent “quantity” as a distance. Two-variable graphs use two perpendicular scale lines.

The vertical line is the y-axis. The horizontal line is the x-axis. The zero point in common to both axes is the origin.

Scatter diagram—a graph that plots the value of one variable on the x-axis and the value of the associated variable on the y-axis. A scatter diagram can make clear the relationship between two variables.

II. Graphs Used in Economic Models •

Graphs are used to show the relationship between variables. Graphs can immediately convey the relationship between the variables: • A positive relationship (or direct relationship)—when the variable on the x-axis increases the variable on the y-axis increases. A straight line is a linear relationship.

• A negative relationship (or inverse relationship)—when the variable on the x-axis increases, the variable on the y-axis decreases.

• A maximum or a minimum—when the variable has a highest or lowest value.

III. The Slope of a Relationship •

• • •

The slope of a curve equals the change in the value of the variable on the vertical axis at the point where the slope is being calculated divided by the change in the value of the variable on the horizontal axis at the relevant point.

• In terms of symbols, the slope equals y/x, with  standing for “change in.”

The slope of a straight line is constant. The slope is positive if the variables are positively related and negative if the variables are negatively related.

The slope of a curved line at a point equals the slope of the straight line that is tangent to the curved line at the point.

The slope of a curved line across an arc equals the slope of a straight line between the two points on the curved line.

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WHAT IS ECONOMICS?

IV. Graphing Relationships Among More Than Two Variables •

A. When a relationship involves more than two variables, we can plot the relationship between two of the variables by holding other variables constant.

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THE ECONOMIC PROBLEM

The Big Picture Where we have been: Chapter 1 introduced the economic reality that wants exceed the resources available to satisfy them—we face scarcity. Chapter 2 reinforces these central themes by laying out the core economic model, the Production Possibilities Frontier, or PPF, and uses it to illustrate the concepts of tradeoff and opportunity cost. Chapter 2 further details the concepts of marginal cost and marginal benefit, presenting a first look at the concept of efficiency. The second half of the chapter begins with a model of exchange between two people that shows the “win-win” situation created through specialization and free trade. The next sections show how those individual gains scale up to economy wide gains. Lastly the traditional circular flow model highlights transformation of resources into final goods and services along with the money used in those markets Where we are going: The key concept of opportunity cost and the widespread tendency for the opportunity cost of a good to increase as the quantity produced of that good increases returns in Chapter 3 when we explain the supply curve. For Micro classes, we see it again in Chapters 10 and 11 when we study a firm’s costs and cost curves. Preferences return and are treated more rigorously when we explain marginal utility theory in Chapter 8 and indifference curves in Chapter 9. Efficiency returns in Chapter 5 when we study the efficiency of markets and first preview the impediments to efficiency. The gains from trade are explored more completely in the context of international trade in Chapter 7 in Microeconomics and Chapter 15 of Macroeconomics. Finally, the role of markets and prices in allocating resources and coordinating activity is an ongoing theme throughout most of the rest of the text. The next task, in Chapter 3, is to develop the central demand and supply model.

New in the Thirteenth Edition Chapter 2 has been slightly reorganized and some new content has been added. The Worked Problem is now located before the Summary for all chapters in the book. The “Economics in the News” has a new article on President Trump’s potential help to Rust Belt manufacturing.

The introduction includes some teaser questions about President Trumps proposed trade policy changes. The first “Economics in the News” has new content regarding kale production.

“Economics in Action” has been updated for Hong Kong being “caught up” rather than “catching up” to the United States.

A major change to this chapter is that the Economic Growth section and Gains from Trade section have been switched so that Gains from Trade are explained first. This order is a more natural way to show the microeconomic foundations of macroeconomic concepts. As before, Gains from Trade illustrates Joe and Liz engaged in trade and the mutual benefits that result. .

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The explanations have been refined along with an additional figure highlighting the “Liz-Joe Economy.” The chapter then moves into Economic Growth and Economic Coordination. Here again, Parkin has enhanced the discussion by adding a figure “How Economic Growth Changes What We Produce” along with text narrative to accompany it.

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Lecture Notes

The Economic Problem • • •

I.

Scarcity creates the need to make choices.

Economic choices can be evaluated in terms of their efficiency.

We can expand possible choices through capital accumulation and specialization and trade.

Production Possibilities and Opportunity Cost • •

The production possibilities frontier (PPF) is the boundary between those combinations of goods and services that can be produced and those that cannot given available resources and technology.

Consider the production choices for two goods: books and movies. The table with the data for the PPF is below and a figure showing the PPF is to the right.

A B C D

• • •

Books 0 200 400 600

Movies 600 500 300 0

Production points beyond the PPF are not attainable without increases in resources or technology (these factors shift the PPF); Production points on and within the PPF are attainable, but production points within the PPF, such as point Z, are inefficient. It is possible to get more of one good without giving up any of the other.

The PPF illustrates how scarcity creates the need to make choices. Producing more books (moving from point A to point B) means producing fewer movies, and producing more movies (moving from point C to point B) means producing fewer books.

Using the PPF above, make a point outside the PPF and ask the students about it. Once they state it is not possible, ask them how we could get there. After they highlight a few shifters, summarize for them that the resources and technology we held constant when we drew the PPF now relocate it when they change.

Now give them an example of a new movie camera invention and ask them if this will help us get more books? You will likely get an immediate round of “NO.” Reply, “Are you sure?” and you should be able to find a student who sees that the new resource frees up other resources that can now be used for more books. Show them graphically a shift that is pinned at the book axis and it will open their eyes to how technology and resource growth in any sector can make more of all goods!

Production Efficiency

Production is efficient only on the frontier.

• We achieve production efficiency if we cannot produce more of one good without producing less of some other good.

• Inside the frontier (point Z), production is inefficient. Resources could be better employed to increase production of both books and movies.

Tradeoff Along the PPF •

Moving along the PPF, there is always a tradeoff involved in diverting resources from the production of one thing to another. We gain one thing but at the opportunity cost of losing something else. .

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The key here is to make sure the student understands that given scarcity, because we produce one thing, we cannot produce something else. Some students will see the tradeoff immediately as a cost (giving up something), but they will incorrectly interpret that cost as only that valued in money units. To eliminate this ambiguity (better now than later), ask them to think about a meal they purchased recently. Now ask them what the money cost was as well as what else they might have picked for a meal? Most students pick up on this concept quickly with one or two more examples. And since this is a consumption example, tell them to put themselves in the place of an office manager, who must produce a service but can do so only given tradeoffs. While money costs are measurable and useful, propose to the students that opportunity costs are indeed even more useful in identifying the tradeoffs made in production.

Opportunity Cost • •

•

The opportunity cost of an action is the highest valued alternative forgone.

Opportunity cost is a ratio; it is the cost of an additional unit of a good measured in terms of what was given up to obtain that additional unit. The formula to calculate opportunity cost is decrease in the quantity produced of one good divided by the increase in the quantity produced of a another good.

Efficiency means that the opportunity cost of producing more books or movies is the tradeoff along the frontier.

Increasing Opportunity Costs • •

•

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The “bowed-out” shape of the PPF reflects the principle of increasing opportunity cost.

Not all resources are the same, which is why the PPF bows out. Publishers are better at producing books and Hollywood studios are better at producing movies. Moving along the frontier and producing more movies inevitably means that more and more publishers must produce movies. As this happens, the increase in movies becomes smaller and the decrease in books becomes larger.

Emphasize the intercepts where the PPF crosses the axes. Take the vertical intercept in the figure.

At this point all resources are used to produce movies. Basically to get to that point the economy has crammed and slammed every resource into movie production. Now when the economy moves down the PPF to produce the first book, that book is really inexpensive—has very low opportunity cost—because the economy uses resources better suited for book production first rather than movies.

As more and more resources are diverted from production of one good to another, the smaller the additional increase in the production of the one good will be and the larger the decrease in the production of the other good.

You can bring in the relationship of slope and opportunity cost here if you want. OPTION 1: A soft way to bring in slope is to offer it as a double check on calculating marginal cost: “The opportunity cost of whatever is being measured on the horizontal axis is equal to the magnitude of the slope of the PPF.” OPTION 2: You can also introduce the slope of a curve as the slope of a tangent line to the curve, that is, the slope of the line that is “just kissing” the curve at a single point.

The bowed-out shape is a key feature of typical PPFs, often overlooked by the student (and too often not accentuated by the instructor). The key here is to link the ever increasing opportunity cost exhibited by the shape of a bowed out PPF with that of the marginal cost curve, which is upward sloping. Simply stated, some resources are better suited for the production of one good or the other.

To make the PPF model useful, it was necessary to simplify. By considering the case where production of all goods other than two remain fixed, we can use a relatively simple picture to see how concepts apply to the real world. With three goods, we would have a 3-D frontier surface. With more than 3 goods, it would .

THE ECONOMIC PROBLEM

15

be impossible to represent the frontier using a graph. The cool thing is that all relevant results of the 2-D model are true in the N-good model.

II. Using Resources Efficiently

Which point on the PPF best serves the public interest? To answer this question, we must measure and compare costs and benefits of different points.

The PPF and Marginal Cost • •

Marginal cost is the opportunity cost of producing one more unit of a good.

As more books are produced, the marginal cost of a book increases. The table shows the marginal cost of producing books from the PPF data presented before and the figure shows the upward sloping marginal cost curve.

A

Books 0

Marginal cost of a book (movies per book) 0.5

B

200

C

400

D

600

1.0 1.5

Preferences and Marginal Benefit • • •

Preferences are a description of a person’s likes and dislikes.

The marginal benefit of a good or services is the benefit received from consuming one more unit of it.

The principle of decreasing marginal benefits is why the marginal benefit curve in the figure above slopes downward.

You might have some students that have had a microeconomics course in their past, and have already been introduced to the concept of marginal cost and marginal benefit. And, they might inquire if the marginal benefit curve is linked to the Law of Diminishing Marginal Utility. While this might be adequate discussion for an advanced undergraduate course, and certainly a graduate micro seminar, pass it up in your principles course. Let the student know that the goal is to employ demand side concepts, in a marginal sense. As such, key in on the fact that the marginal benefit curve can be characterized as a willingness to pay curve.

Keep the discussion of marginal cost and marginal benefit separate and distinct, making sure that the student realizes these are in essence the foundation of market forces (supply and demand, respectively).

While the PPF can tell us the opportunity costs in production, and the tradeoffs therein, it is the market that allows us to determine the allocatively efficient point. Allocative efficiency only occurs with a balance between benefits and costs, at the margin.

Allocative Efficiency Allocative efficiency occurs only when marginal benefit equals marginal cost.

• In the figure, when 100 books per month are produced, the marginal benefit from another book exceeds its marginal cost, which means that people prefer another book more than the movies they must give up. .

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• •

When the allocatively efficient number of books, 200 per month, is produced, the PPF in the previous figure shows that the allocatively efficient number of movies is 500 movies per month.

When marginal cost equals marginal benefit it is impossible to make people better off by reallocating resources.

III. Gains from Trade

Specialization and trade expand consumption possibilities

Comparative Advantage and Absolute Advantage • •

•

A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.

The PPF shows opportunity cost. In the figure the opportunity cost of a bushel of wheat in Canada is 1/4 of a computer and in Japan it is 1 computer. In Canada the opportunity cost of a computer is 4 bushels of wheat and in Japan it is 1 bushel of wheat.

Canada has a comparative advantage in producing wheat and Japan has a comparative advantage in producing computers.

A person has an absolute advantage if that person is more productive than others in that activity or activities. A person (or country) can have an absolute advantage in all activities but that person (or country) will not have a comparative advantage in all activities.

An easy way for students to remember the difference between comparative and absolute advantages is that with comparative advantage, the opportunity costs comparison matters. If one has a comparative advantage in producing something, they should specialize in production of that good or service. An absolute advantage can be characterized by being able to “absolutely out-produce” the other economic agent. Even though a country might have absolute advantages, it should not produce everything, and should focus on identifying its comparative advantages.

Achieving the Gains from Trade •

When countries specialize by producing the good in which each country has a comparative advantage more goods in total can be produced. If without trade Canada and Japan each produce at point A, a total of 8 computers and 16 bushels of wheat are produced. If they specialize according to comparative advantage, Japan produces at point B* and Canada produces at point B for a combined total of 12 computers and 24 bushels of wheat.

•

Trade allows consumption to be different than production for each nation, so Canada can trade wheat for computers and Japan can trade computers for wheat. Because more computers and more wheat are produced, both nations can consume more than they can produce on their own. For example, suppose that the market price of wheat is ½ computer per 1 bushel of wheat. As illustrated, each country can now be consuming at point C .

THE ECONOMIC PROBLEM

17

along the trade line. Note that each country’s consumption point lies beyond its own PPF. •

The gains from trade can now be easily seen in terms of Japan and Canada each gaining 2 computers and 4 bushels of wheat compared to their initial, no-trade consumption points. Note that it is more likely that point C for each country will be on a different point on the trade line according to preferences. In the end, the sum of consumption among the two countries must equal the sum of production (imports=exports). For simplicity, this example has points A and C equal for both countries.

You may want to motivate the gains from trade using an example loosely based on Tom Hanks in the movie Castaway. Ask the students, “Was Tom by himself on the island an economy?” Use a couple goods like fish and coconuts and show Tom’s production possibilities. Discuss what are the essential elements needed to have an economy. Tom produces food and then he consumes it but is this sufficient for us to call him an economy? It is an open-ended question that I end with Tom needing somebody to trade with. Once a new person washes up on shore, the two can specialize in the good for which he or she has a comparative advantage and trade for the other. Give one of them an absolute advantage and then show how consumption possibilities lie outside each person’s production possibilities. This shows the power of specialization and trade in a way that personalizes it for the student.

To show the gains from trade you can use candy or any kind of small trinkets. Make sure that each person initially gets Then: 1. Create several countries with approximately even student populations. Give each country at least 3 or 4 items such as different types of candy. You can have some fun and add in a few entertaining items.

For example: a can of spam, sticks of beef jerky, bubbles, etc.

2. Students record individual happiness value from 1-10 on initial allocation (I use an Excel spreadsheet to easily aggregate data at the end but keeping track on paper is fine).

3. Allow the countries to trade with each other 4. Have the students record their new happiness level after trade.

5. Compare the “happiness” level after trade with that before trade.

Here are the key points that come from the experiment: • Both parties become better off when they engage in voluntary trade.

• Even without production, trade creates value.

IV. Economic Growth

Economic growth expands production possibilities and shifts the PPF outward.

• Technological change (the development of new goods and of better ways of producing goods and services) and capital accumulation (the growth of capital resources, which includes human capital) lead to economic growth.

You can have some fun and generate some discussion by getting the students to think about what life might be like after another 200 years of economic growth. Provide some numbers: In 2017, income per person in the United States was about $133 a day. In 1808 it was about 70¢ a day, and if the past growth rate prevails for another 200 years, in 2208 it will be $14,000 a day. Emphasize the magic of compound growth. If they think that $14,000 a day is a big income, get them to do a ballpark estimate of the daily income of Bill Gates (about $10 million!). Encourage a discussion of why scarcity is still present even at these large incomes.

The Cost of Economic Growth •

Economic growth requires that resources must be devoted to developing technology or accumulating capital, which means that current consumption decreases. The decrease in current consumption is the opportunity cost of economic growth. .

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CHAPTER 2

A Nation’s Economic Growth • •

Countries that devote a higher share of resources to developing technology or accumulating capital are more likely to grow faster.

Some nations, such as Hong Kong, have chosen faster capital accumulation at the expense of current consumption and so have experienced faster economic growth.

Running through the above example can really help students catch on to how economic growth is linked to choices (less consumption now for more later). You may wish to demonstrate more consumption or more capital biased shifts of the PPF, to demonstrate changes in opportunity costs.

Changes in What We Produce • • •

In a low-income country, just producing enough food is a high priority, and the marginal benefit from food is high. So in Ethiopia, agriculture accounts for a large 36 percent of total production.

In China, where production per person is 7 times that of Ethiopia, agriculture shrinks to 9 percent of total production and industry expands to 41 percent.

Further investment in capital and in advanced robot technologies expand production possibilities to the level in the United States, which today is 4 times (per person) its level in China.

V. Economic Coordination Firms and Markets • •

A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services.

A market is any arrangement that enables buyers and sellers to get information and to do business with each other.

Property Rights and Money • •

The social arrangements that govern the ownership, use, and disposal of resources, goods, and services are called property rights. Types of property include real (buildings and land), financial (stocks and bonds) and intellectual (ideas and technology).

Money is anything generally accepted as a means of payment. Money’s main purpose is to facilitate trade.

Students are usually fixated on money, but ask them to dig deeper. It is what we can do or buy with money that brings us happiness not the actual bills themselves. Our focus on money creates a “veil” that hides the real economic engine of capitalism.

Circular Flows Through Markets •

Firms and households interact in markets and it is this interaction that determines what will be produced, how it will be produced, and who will get it.

Coordinating Decisions •

Prices within markets coordinate firms’ and households’ decisions.

Everyone knows what prices are. But not everyone knows why prices rise or fall. The point is that no one needs to know why a price has changed when making the choice to buy or sell. All that someone needs to know is what the price is relative to what he or she believes the item to be worth.

•

Enforced property rights ensure that exchange is voluntary (not theft). Property rights and prices help insure that production takes place efficiently without waste because the owner of a firm has the property right to any profit the firm can earn.

.

THE ECONOMIC PROBLEM

19

Willingness to pay affects production and production affects willingness to pay. It would appear that we have the classic “which came first, the chicken or the egg” conundrum. However, in the next chapter, we will discuss the most powerful model in economics, Demand and Supply, which allows us to think clearly about the behavior of markets.

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20

CHAPTER 2

Additional Problems 1.

2.

Jane’s Island’s production possibilities are given in the table to the right. a. Draw a graph of the production possibility possibilities frontier on Jane’s Island. b. What are Jane’s opportunity costs of producing corn and cloth at each output in the table?

In problem 1, Jane is willing to give up 0.75 pounds of corn per yard of cloth if she has 2 yards of cloth; 0.50 pounds of corn per yard of cloth if she has 4 yards of cloth; and 0.25 pound of corn per yard of cloth if she has 6 yards of cloth. a. Draw a graph of Jane’s marginal benefit from corn. b. What is Jane’s efficient quantity of corn?

3.

4.

Corn (pounds per month) 3.0 2.0 1.0 0

Joe’s production possibilities are given in the table to the right. What are Joe’s opportunity costs of producing corn and cloth at each output in the table?

Corn (pounds per month) 6 4 2 0

and and and and

Cloth (yards per month) 0 2 4 6

Cloth (yards per month) 0 1.0 2.0 3.0

In problems 1 and 2, Jane’s Island produces and and consumes 2 pounds of corn and 2 yards of cloth. Joe’s and Island produces and consumes 2 pounds of corn and and 2 yard of cloth. Now the islands begin to trade. and a. What good does Jane sell to Joe and what good does Jane buy from Joe? b. If Jane and Joe divide the total output of corn and cloth equally, what are the gains from trade?

Solutions to Additional Problems 1.

a.

b.

Jane’s Island’s PPF is a straight line. To make a graph of Jane’s Island’s PPF measure the quantity of one good on the x-axis and the quantity of the other good on the y-axis. Plot the quantities in each row of the table. Figure 2.1 illustrates Jane’s Island’s PPF. The opportunity cost of 1 pound of corn is 2 yards of cloth. The opportunity cost of the first pound of corn is 2 yards of cloth. To find the opportunity cost of the first pound of corn, increase the quantity of corn from 0 pounds to 1 pound. In doing so, Jane’s Island’s production of cloth decreases from 6 yards to 4 yards. The opportunity cost of the first pound of corn is 2 yards of cloth. Similarly, the opportunity costs of producing the second pound and the third pound of corn are 2 yards of cloth.

The opportunity cost of 1 yard of cloth is 0.5 pound of corn. The opportunity cost of producing the first 2 yards of cloth is 1 pound of corn. To calculate this opportunity cost, increase the quantity of cloth from 0 yards to 2 yards. Jane’s Island’s production of corn decreases from 3 pounds to 2 pounds. .

THE ECONOMIC PROBLEM

21

Similarly, the opportunity cost of producing the second 2 yards and the third 2 yards of cloth are 1 pound of corn.

2.

a.

b.

3.

4.

The marginal benefit curve slopes downward. To draw the marginal benefit curve from cloth, plot the quantity of cloth on the x-axis and the willingness to pay for cloth (that is, the number of pounds of corn that Jane is willing to give up to get a yard of cloth) on the y-axis, as illustrated in Figure 2.2.

The efficient quantity is 4 yards a month. The efficient quantity to produce is such that the marginal benefit from the last yard equals the opportunity cost of producing it. The opportunity cost of a yard of cloth is 0.5 pound of corn. The marginal benefit of the fourth yard of cloth is 0.5 pound of corn. And the marginal cost of the fourth yard of cloth is 0.5 pound of corn.

Joe’s Island’s opportunity cost of a pound of corn is 1/2 yard of cloth, and its opportunity cost of a yard of cloth is 2 pounds of corn. When Joe’s Island increases the corn it produces by 2 pounds a month, it produces 1 yard of cloth less. The opportunity cost of 1 pound of corn is 1/2 yard of cloth.

Similarly, when Joe’s Island increases the cloth it produces by 1 yard a month, it produces 2 pounds of corn less. The opportunity cost of 1 yard of cloth is 2 pound of corn. a.

b.

Jane’s Island sells cloth and buys corn. Jane’s Island sells the good in which it has a comparative advantage and buys the other good from Joe’s Island. Jane’s Island’s opportunity cost of 1 yard of cloth is 1/2 pound of corn, while Joe’s Island’s opportunity cost of 1 yard of cloth is 2 pounds of corn. Jane’s Island’s opportunity cost of cloth is less than Joe’s Island’s, so Jane’s Island has a comparative advantage in producing cloth.

Jane’s Island’s opportunity cost of 1 pound of corn is 2 yards of cloth, while Joe’s Island’s opportunity cost of 1 pound of corn is 1/2 yard of cloth. Joe’s Island’s opportunity cost of corn is less than Jane’s Island’s, so Joe’s Island has a comparative advantage in producing corn.

With specialization and trade, together they can produce 6 pounds of corn and 6 yards of cloth and each will get 3 pounds of corn and 3 yards of cloth—an additional 1 pound of corn each and an additional 1 yard of cloth each. Hence the total gains from trade are 2 yards of cloth and 2 pounds of corn.

Additional Discussion Questions 1.

Use the PPF model to analyze an “Arms Race” between nations. You might like to get the students to realize how useful even a simple economic model (such as the PPF model) is for helping us understand and interpret important political events in history. Draw a PPF for military goods and civilian goods production (or, simply, the traditional example of “guns versus butter”). Then draw another PPF for a country that is about twice the size of the first, but with the same degree of concavity as the PPF for the first country. Now assume that each country considers the other as a mortal “enemy,” and that they engage in a costly .

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CHAPTER 2

“arms race.” Each country picks a point on the PPF that produces an equal level of military output (in absolute terms).

What would happen if the larger country decided to increase military production?

Emphasize that while the distance on the military output axis at the point of production is equal for both countries, the resulting distance on the civilian output axis is (by definition) a smaller quantity for the smaller country. The large country can create significant economic and political pressures on the government of the small country by forcing the small country to match the increase in military production. The PPF reveals how much more additional civilian output is forgone by the citizens of the small economy relative to the citizens of the larger economy. Emphasize also that the opportunity cost of civilian goods is higher for the smaller country.

What were the economic repercussions of the Cold War? History and political science majors quickly perceive that these two PPF models reflect the Cold War relationship between the United States and the U.S.S.R. during the early 1980s. The Reagan administration increased U.S. military expenditures during the early 1980s to a post–Viet Nam War peak of 6.6 percent of GDP (as compared to about 3.5 percent of GDP in the late 1990s). Many experts agree that this strategy contributed to the many political and economic pressures that ultimately lead to the dissolution of the U.S.S.R. What are the implications for the next 50 years? China is currently the world’s second largest economy. It could become the biggest by mid-century. How does this development influence the strategic balance and the position of the United States?

12. Using the PPF model to analyze global environmental agreements between nations.

This application of the PPF is a more “green” perspective that uses the same logic as the “Arms Race” on a timely international policy issue. Compare a rich economy PPF to a poor economy PPF, each with the same degree of concavity. (Production levels are now measured as output per person.) The goods are now “cleaner air” and “other goods and services.”

What if the citizens of each country were required to make equal reductions in perperson greenhouse gas emissions? Show an equal quantity increase in per person output on the clean air axis for both countries’ PPF curves. Show how the opportunity cost of requiring additional pollution reduction (cleaner air) of equal amounts per person is much greater for the citizens of a poorer country than for the citizens of the richer country. This fact has been used to persuade developed countries (like the United States) to accept larger pollution reduction targets than developing countries (like China, India, and African nations).

3.

Why do some of the brightest students not get Recreation Marginal cost a 4.0 GPA? The answer—because it doesn’t (hours per day) (GPA points per hour) achieve allocative efficiency—can now be 0.5 0.1 approached. The first conceptual step is to 1.5 0.2 derive the marginal cost curve from the PPF. 2.5 0.3 The table provides eight points on the MC curve.

3.5 0.4 Tell the students that this table is from a PPF 4.5 0.5 between hours spent at recreation and GPA. Use 5.5 0.6 this opportunity to explain why we plot 6.5 0.7 marginal values at the midpoints of changes 7.5 0.8 because the marginal cost at the midpoint approximately equals the average of the opportunity costs across the interval.

.

THE ECONOMIC PROBLEM

23

The students must now think about preferences for recreation and study. You’ll be surprised how many students want to derive preferences from the PPF! Explain that the PPF provides the constraint—what is feasible—and preferences provide the objective—what is desirable in the opinion of the chooser.

Each additional hour of recreation likely yields a smaller marginal benefit to the student. Translate this to the proposition that the student’s willingness to give up GPA points for additional hours of recreation decreases and provide a table similar to that in Figure 2.3 that captures this observation. The table has a preference schedule.

Stress once again that this table did not come from the PPF.

Recreation

Willingness to pay

(hours per day)

(GPA points per hour)

0.5 1.5 2.5 3.5 4.5 5.5 6.5 7.5

0.7 0.6 0.5 0.4 0.3 0.2 0.1 0

To determine the efficient amount of recreation and hence study time, the student must ask “Do I study a little bit longer?” That is the question.

Walk the student through the thought experiment: 1. If I study for 8 hours a day I get a 4.0, but I am willing to pay much more than I will pay if a take a bit of time off studying and have some fun. So I will be better off if study less and take more recreation time.

2.

If I don’t study at all I get a 0.4, and I am paying much more in lost GPA than I am willing to pay for the last bit of fun. So I will be better off if I study more and take less recreation time.

3.

The only allocation at which I can’t become better off by studying a little bit more or a little bit less is where I am just willing to pay what the last bit of recreation costs— where marginal cost equals marginal benefit.

In this example, the student studies for 4.5 hours and takes 3.5 hours a week of recreation time.

Explain that there is nothing strange or wrong with the fact that the student gets no net benefit from the last seconds-worth of recreation time. He or she is just willing to pay what it costs him or her.

4.

Gains from Trade The gain from trade is a real eye-opener for students. Their first reaction is one of skepticism. Convincing students of the power of trade to raise living standards and the costs of trade restriction is one of the most productive things we will ever do. Here are some questions to drive home the idea of comparative advantage: Why didn’t Billy Sunday do his own typing? Billy Sunday, an evangelist in the 1930s, was reputed to be the world’s fastest typist. Nonetheless, he employed a secretary who was a slower typist than he. Why? Because in one hour of preaching, Billy could raise several times the revenue that he could raise by typing for an hour. So Billy plays to his comparative advantage.

Why doesn’t Martha Stewart bake her own bread? Martha Stewart is probably a better cook than most people, but she is an even better writer and TV performer on the subject of food. So Martha plays to her comparative advantage and writes about baking bread but buys her bread.

Why doesn’t Vinnie Jones play soccer? Vinnie Jones was one of the world’s best soccer players. But he stopped playing soccer and started making movies some years ago. Why?

.

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Because, as he once said, “You go to the bank more often when you’re in movies.” Vinnie’s comparative advantage turned out to be in acting.

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C h a p t e r

3

DEMAND AND SUPPLY

The Big Picture Where we have been: In Chapter 3, the students have their first encounter with demand and supply and the powerful forces that determine price and quantity in a competitive market. Chapter 3 builds on Chapter 2, which provides the simplest rigorous description of the economic problem and the implications of the pursuit of an efficient use of resources. If you have time, it is worth forging links between Chapters 2 and 3. Chapter 2 explains why we trade in markets.

Chapter 3 shows how trade in markets through the interaction of supply and demand determines where on the PPF the economy operates.

Where we are going: Demand and supply lie at the heart of the principles course. Eventually in the microeconomics class we derive the demand curve and the supply curve from deeper views of the choices that people and firms make. And in the macroeconomic class, the lessons learned here apply, albeit with subtle differences, to the aggregate supply-aggregate demand model.

New in the Thirteenth Edition The content of this chapter is largely the same except for the Economics in the News sections, which are now replaced with new current topics of gasoline and orange juice. The gasoline article covers the impact a broken pipeline had on gas prices in the Atlanta area in 2016. The orange juice article is at the end of the chapter along with the extended Economic Analysis of the end-of-chapter articles. Students will take interest in the “Why is Tuition So High?” article which provides economic analysis of student loans being the driving force behind the answer.

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CHAPTER 3

Lecture Notes

Demand and Supply I.

Markets and Prices • • • •

In our market-based economy, the interaction of demand and supply in markets determines the prices of goods and services and the quantity produced and consumed.

Changes in demand and/or supply lead to changes in the price of the good or service and in the quantity produced and consumed.

Markets vary in the intensity of competition. This chapter studies a competitive market, which is a market that has many buyers and sellers, so no single buyer or seller can influence price.

The money price of a good or service is the number of dollars that must be given up for it. The ratio of one (money) price to another is called a relative price. A relative price is an opportunity cost. The theory of demand and supply determines relative prices and so when we use the word “price” we mean “relative price.”

To point out the importance of relative prices, ask your students if turkey at 40¢ a pound is a good buy.

Tell them that is all they know—turkey is 40¢ a pound. Generally most students respond that turkey at this price is cheap and a good buy. Then tell them that steak is 8¢ a pound. Now is turkey such a good buy?

Students realize that the relative price of turkey is 5 pounds of steak per pound of turkey and so turkey is actually expensive. Point out to them that these money prices are actual prices from circa 1800. At that time, turkey was relatively quite expensive because turkeys could fly and needed to be hunted rather than harvested! Also point out to them the unimportance of the money price and the crucial importance of the relative price.

II.

Demand • •

The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price.

The law of demand states that other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater the quantity demanded. The law of demand occurs for two reasons: • Substitution Effect: When the relative price of good changes, the opportunity cost of the good changes. An increase in the price increases the opportunity cost of buying the good and people respond by buying less of the good and buying more of its substitutes.

• Income Effect: A change the price of a good changes the amount that a person can afford to buy.

When the price of a good rises, people cannot afford to buy the same quantities that they purchased before, so the quantities bought of some goods and services must decrease.

Normally the good whose price rises is one of the goods for which less is purchased.

.

DEMAND AND SUPPLY

25

Demand Curve and Demand Schedule •

•

•

The demand for a good Price Quantity refers to the entire (dollars demanded relationship between the per (units) price of the good and the unit) quantity demanded of 1 50 the good. The table gives 2 40 a demand schedule.

3 30 A demand curve shows 4 20 the relationship between 5 10 the quantity demanded of a good and its price when all other influences on consumers’ planned purchases remain the same.

The figure illustrates the demand curve resulting from the demand schedule.

The demand curve is a willingness-to-pay curve— for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output which means that a demand curve is a marginal benefit curve.

Of the hundreds of classroom experiments that are available today, very few are worth the time they take to conduct. The classic demand-revealing experiment is one of the most productive and worthwhile ones.

Bring to class two bottles of ice-cold, ready-to-drink Mt. Dew, bottled water, or sports drink. (If your class is very large, bring six bottles). Tell the students that you have these drinks and ask them to indicate if they would like one. Most hands will go up. Tell the class that you are going to sell them to the high bidder. Tell them that this auction is real. The winner will get the drink and will pay. Ask for a show of hands of those who have some cash and can afford to buy a drink. Explain that these indicate an ability to buy but not a definite plan to buy. Now begin the auction. Appoint a student to count hands (more than one for a big class). Begin at a low price: say 10¢ a bottle and count the number willing to buy. Raise the price in 10¢ increments and keep the tally of the number who are willing to buy at each price. When the number willing to buy equals the number of bottles you have for sale, do the transactions. (If you make a profit, and you might do so, tell the students that the profit, small though it is, will go the department fund for undergraduate activities—and deliver on that promise.) Now use the data to make a demand curve for Mt. Dew (or other drink) in your classroom today. You can easily emphasize the law of demand. And, now that you have a demand curve, you can do some thought experiments that will shift it. Ask: How would this demand curve have been different if the temperature in the classroom was 10 degrees higher/lower? How would this demand curve have been different if half the class was sick and absent today? How would this demand curve have been different if there was a Coke machine right in the classroom?

A Change in Demand (Demand Shifters) •

When any factor that influences buying plans other than the price of the good changes, there is a change in demand and the demand curve shifts. An increase in demand shifts the demand curve rightward and a decrease in demand shifts the demand curve leftward. Six factors change demand: • Prices of Related Goods: A substitute is a good that can be used in place of another good (tea and coffee) and a complement is a good that is used in conjunction with another good. (sugar and coffee). A rise in the price of a substitute or a fall in the price of a complement increases the demand for the good.

• Expected Future Prices: If the price of a good is expected to rise in the future, the demand for the good today increases.

• Income: A normal good is one for which demand increases as income increases; an inferior good is one for which demand decreases as income increases. .

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• • •

Expected Future Income and Credit: When expected future income increases, demand today increases. When credit becomes easier to obtain, demand increases.

Population: The larger the (relevant) population, the greater the demand.

Preferences: Preferences are an individual’s attitudes toward goods and services. If people “like” a good more, the demand for it increases.

A Change in the Quantity Demanded Versus a Change in Demand •

•

A change in price results in a movement along the demand curve, which is change in the quantity demanded. A change in other factors shifts the demand curve, which is a change in demand.

In the figure, the movement along demand curve D0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity demanded.

The shift of the demand curve from D0 to the new demand curve D1 is a change in demand.

III. Supply •

•

The price of a good or service affects the quantity firms plan to sell. The quantity supplied of a good or service is the amount that firms plan to sell during a given time period at a particular price.

The law of supply states that other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So the price must rise in order to induce firms to increase the quantity they produce.

Supply Curve and Supply Schedule •

•

•

The supply of a good Price Quantity refers to the entire (dollars supplied relationship between per (units) the price of the good unit) and the quantity 1 10 supplied of the good.

2 20 The table gives a 3 30 supply schedule.

4 40 A supply curve shows 5 50 the relationship between the quantity supplied of a good and its price when all other influences on producers’ planned sales remain the same. The figure illustrates the supply curve resulting from the supply schedule.

The supply curve is a minimum-supply-price curve—for each quantity, the price along the supply curve is the lowest price a producer must receive in order to produce that unit of output which means that a supply curve is a marginal cost curve.

A Change in Supply (Supply Shifters) •

When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. Six factors change supply: .

DEMAND AND SUPPLY

• •

• • • •

27

Prices of Productive Resources: If the price of a resource used to produce the good rises, the supply of the good decreases.

Prices of Related Goods Produced: A substitute in production is a good that can be produced using the same resources and a complement in production is a good that must be produced with the initial good. A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good.

Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases.

Number of Suppliers: If the number of suppliers increases, the supply increases.

Technology: Technology refers to the ways in which factors of production are used to produce a good. A technological advance increases the supply of a good.

The State of Nature: The state of nature includes all natural forces that influence supply. Bad weather or an earthquake decreases the supply of a good.

A Change in the Quantity Supplied Versus a Change in Supply •

•

A change in price results in a movement along the supply curve, which is change in the quantity supplied. A change in other factors shifts the supply curve, which is a change in supply.

In the top figure, the movement along supply curve S0 from point a to point b as a result of the price rising from $2 to $4 is a change in the quantity supplied. The shift of the supply curve from S0 to the new supply curve S1 is a change in supply.

IV. Market Equilibrium • •

An equilibrium is a situation in which opposing forces balance.

The equilibrium price is the price at which the quantity demanded equals the quantity supplied.

The equilibrium quantity is the quantity bought and sold at the equilibrium price. In the figure, the equilibrium price is $3 and the equilibrium quantity is 30 per week.

Price as a Regulator and Price Adjustments • •

• •

The price of a good regulates the quantities demanded and supplied.

Shortage: If the price is below the equilibrium price, consumers plan to buy more than firms plan to sell. A shortage results, which forces the price higher, toward the equilibrium price. In the figure, there is a shortage at any price below $3 and so the price is forced higher, toward the equilibrium price.

Surplus: If price is above the equilibrium, firms plan to sell more than consumers plan to buy. A surplus results, which forces the price lower, toward the equilibrium price. In the figure, there is a surplus at any price above $3 and so the price is forced lower, toward the equilibrium price.

The price continues to adjust until the quantity supplied equals quantity demanded.

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To help students have a base of knowledge from which build tell them to memorize “Home Base”—the basic Supply and Demand curves showing an initial starting position with proper labels on the axis’ and an initial equilibrium, P0 and Q0 on the axis at the intersection of the two curves. “Home Base” provides them a starting place for every story problem they face. Then as you work through examples, be sure to ask them what “shifter” is changing. This procedure will keep them using the economic tool rather than just going with a gut feeling.

The magic of market equilibrium and the forces that bring it about and keep the market there need to be demonstrated with the basic diagram, with intuition, and, if you’ve already used the demand experiment outlined above, with hard evidence in the form of the class activity. Using the experiment is straightforward. Start by explaining that in that market, the supply was fixed (vertical supply curve) at the quantity of bottles that you brought to class. The equilibrium occurred where the market demand curve (demand by the students) intersected your supply curve. Point out that the trades you made in your little economy made both buyers and sellers better off.

Back in the dim mists of time, circa 1870 or so, economists struggled to understand if it was the supply or the demand that determined the price and quantity of a good. Nowadays we know that these efforts were misguided. To borrow from the great economist Alfred Marshall, demand and supply curves are like the blades on a pair of scissors. It does not make sense to ask which blade does the cutting because the cutting takes both blades and occurs at the intersection of the two blades. Likewise, it takes both the demand and supply to determine the price and quantity and the price and quantity are determined at the intersection of the demand and supply curves.

V.

Predicting Changes in Price and Quantity

The demand and supply model can be used to determine how changes in factors affect a good’s price and quantity.

A Change In Demand •

•

• •

If the demand for a good or service increases, the demand curve shifts rightward. As a result, the equilibrium price rises and the equilibrium quantity increases.

If the demand for a good or service decreases, the demand curve shifts leftward. As a result, the equilibrium price falls and the equilibrium quantity decreases.

Supply does not change and the supply curve does not shift. Instead there is a change in the quantity supplied and a movement along the supply curve.

The figure illustrates an increase in demand. In the figure the demand curve shifts from D0 to D1. As a result, the equilibrium price rises from $3 to $4 and the equilibrium quantity increases from 30 to 40.

The supply curve does not shift; there is, however, a movement along the supply curve.

An Economic in the News feature discusses the factors that have led to higher college tuition. Because enrollment has also increased, the analysis concludes that increases in demand are the factor that has created the higher tuition.

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DEMAND AND SUPPLY

29

A Change In Supply •

•

•

•

If the supply of a good or service increases, the supply curve shifts rightward. As a result, the equilibrium price falls and the equilibrium quantity increases.

If the supply of a good or service decreases, the supply curve shifts leftward. As a result, the equilibrium price rises and the equilibrium quantity decreases.

Demand does not change and the demand curve does not shift. Instead there is a change in the quantity demanded and a movement along the demand curve.

The figure illustrates an increase in supply. In the figure the supply curve shifts from S0 to S1. As a result, the equilibrium price falls from $3 to $2 and the equilibrium quantity increases from 30 to 40. The demand curve does not shift; there is, however, a movement along the demand curve.

An Economic in the News explores the factors that led to a rise in the price of gasoline in Atlanta in September 2016. The analysis concludes that a decrease in supply from a broken pipeline lies behind the rise in price.

The whole chapter builds up to this section, which now brings all the elements of demand, supply, and equilibrium together to make predictions. Students are remarkably ready to guess the consequences of some event that changes either demand or supply or both. They must be encouraged to work out the answer and draw the diagram. Explain that the way to answer any question that seeks a prediction about the effects of some event(s) on a market has five steps. Once you have already worked an example or two, walk them through the steps and have one or two students work some examples in front of the class. The five steps are: 1. Draw a demand-supply diagram and label the axes with the price and quantity of the good or service in question.

2. Think about the event(s) that you are told occur and decide whether they change demand, supply, or both demand and supply.

3. Determine if the events that change demand or supply bring an increase or a decrease.

4. Draw the new demand curve and supply curve on the diagram. Be sure to shift the curve(s) in the correct direction—leftward for decrease and rightward for increase. (Lots of students want to move the curves upward for increase and downward for decrease—this view works ok for demand but is exactly wrong for supply. So emphasize the left-right shift.)

5. Find the new equilibrium and compare it with the original one.

It is critical at this stage to return to the distinction between a change in demand (supply) and a change in the quantity demanded (supplied). You can now use these distinctions to describe the effects of events that change market outcomes. At this point, the students know enough for it to be worthwhile emphasizing the magic of the market’s ability to coordinate plans and reallocate resources.

Demand and Supply Change in the Same Direction •

If both the demand and the supply of a good or service increase, both the demand and supply curves shift rightward. The quantity unambiguously increases but the effect on the price is ambiguous.

• If the increase in demand is greater than the increase in supply, the price rises. .

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• •

If the increase in demand is the same size as the increase in supply, the price does not change.

If the increase in demand is less than the increase in supply, the price falls.

.

DEMAND AND SUPPLY

•

•

31

If both the demand and the supply of a good or service decrease, both the demand and supply curves shift leftward. The quantity unambiguously decreases but the effect on the price is ambiguous.

• If the decrease in demand is greater than the decrease in supply, the price falls.

• If the decrease in demand is the same size as the decrease in supply, the price does not change.

• If the decrease in demand is less than the decrease in supply, the price rises.

The figure illustrates an increase in both demand and supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium price does not change and the equilibrium quantity increases from 30 to 50.

Demand and Supply Change in the Opposite Directions •

•

•

If the demand increases and the supply decreases, the demand curve shifts rightward and the supply curve shifts leftward. The price unambiguously rises but the effect on the quantity is ambiguous.

• If the increase in demand is greater than the decrease in supply, the quantity increases.

• If the increase in demand is the same size as the decrease in supply, the quantity does not change.

• If the increase in demand is less than the decrease in supply, the quantity decreases.

If the demand decreases and the supply increases, the demand curve shifts leftward and the supply curves shifts rightward. The price unambiguously falls but the effect on the quantity is ambiguous.

• If the decrease in demand is greater than the increase in supply, the quantity decreases.

• If the decrease in demand is the same size as the increase in supply, the quantity does not change.

• If the decrease in demand is less than the increase in supply, the quantity increases.

The figure illustrates an increase in demand and a decrease in supply. In the figure the demand curve shifts from D0 to D1 and the supply curve shifts from S0 to S1. The shifts are the same size, so the equilibrium quantity does not change and the equilibrium price rises from $3 to $5.

The Economic in the News explores the market for orange juice. Decreases in the demand for frozen orange juice and a disease that has the supply of oranges, led to the price rising and quantity decreasing.

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CHAPTER 3

Consider doing a “Market Experiment” for this chapter because it can bring the supply and demand curve to life for students. If you are using Pearson’s MyEconLab for your course there are some options that are real time or asynchronous. If you want to go “old school,” it is hard to beat an open cry auction in the classroom. Using playing cards, separate buyers and sellers with red and black cards and watch them erupt when the trading bell rings! A quick search online can get you open access to shared resources from professors have been doing this sort of classroom experiment for years.

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Additional Problems 1.

What is the effect on the price of hotdogs and the quantity of hotdogs sold if a. The price of a hamburger rises? b. The price of a hotdog bun rises? c. The supply of hotdog sausages increases? d. Consumers’ incomes increase if hot dogs are a normal good? e. The wage rate of a hotdog seller increases? f. If the wage rate of the hotdog seller rises and at the same time prices of ketchup, mustard, and relish fall?

2.

Suppose that one of the following events occurs: (i) The price of wool rises. (ii) The price of sweaters falls. (iii) A close substitute for wool is invented. (iv) A new high-speed loom is invented. a. b. c. d.

3.

Which of the above events increases or decreases (state which) The demand for wool?

The supply of wool?

The quantity of wool demanded?

The quantity of wool supplied?

Figure 3.1 illustrates the market for bread. a. Label the curves in the figure. b. What are the equilibrium price of bread and the equilibrium quantity of bread?

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4.

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The demand and supply schedules for potato chips are in the table. a. What are the equilibrium price and equilibrium quantity of potato chips? b. If chips were 60 cents a bag, describe the situation in the market for potato chips and explain what would happen to the price of a bag of chips.

Price (cents per bag) 40 50 60 70 80 In problem 4, suppose a new snack food 90 comes onto the market and as a result 100 the demand for potato chips decreases 110 by 40 million bags per week.

5.

Quantity Quantity demanded supplied (millions of bags a week) 170 90 160 100 150 110 140 120 130 130 120 140 110 150 100 160

a. Has there been a shift in or a movement along the supply curve of chips? b. Has there been a shift in or a movement along the demand curve for chips? c. What is the new equilibrium price and quantity of chips?

6.

In problem 5, suppose that a flood destroys several potato farms and as a result supply decreases by 20 million bags a week at the same time as the new snack food comes onto the market. What is the new equilibrium price and quantity of chips?

Solutions to Additional Problems 1.

a.

b.

c.

d.

e.

f.

2.

a.

The price of a hot dog rises, and the quantity of hot dogs sold increases. Hot dogs and hamburgers are substitutes. If the price of a hamburger rises, people buy more hot dogs and fewer hamburgers.

The demand for hot dogs increases. The price of a hot dog rises, and more hot dogs are sold.

The price of a hot dog falls, and fewer hot dogs are sold. Hot dog buns and hot dogs are complements. If the price of a hot dog bun rises, fewer hot dog buns are bought. The demand for hot dogs decreases. The price of a hot dog falls, and people buy fewer hot dogs.

The price of a hot dog falls and more hot dogs are sold. The increase in the supply of hot dog sausages lowers the price of hot dog sausages. Hot dog sausages are a factor used in the production of hot dogs. With the lower priced factor, the supply of hot dogs increases. The price of a hot dog falls and people buy more hot dogs.

The price of a hot dog rises, and the quantity sold increases. An increase in consumers' income increases the demand for hot dogs. As a result, the price of a hot dog rises and the quantity bought increases.

The price of a hot dog rises, and the quantity sold decreases. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs.

The price of a hot dog rises, but the quantity might increase, decrease, or remain the same.

Ketchup, mustard, and relish are complements of hot dogs. If the price of ketchup, mustard, and relish fall, more ketchup, mustard, and relish are bought and the demand for hot dogs increases.

The price of a hot dog rises, and people buy more hot dogs. If the wage of the hot dog seller increases, the cost of producing a hot dog increases and the supply of hot dogs decreases. The price rises, and people buy fewer hotdogs. Taking the two events together, the price of a hot dog rises, but the quantity might increase, decrease, or remain the same. (ii) and (iii) Wool is used in the production of sweaters. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the .

DEMAND AND SUPPLY

b. c.

d.

3.

a. b.

4.

a.

b.

5.

a. b. c.

6.

35

demand for wool increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. If a close substitute for wool is invented, some sweater producers will switch from wool to the substitute. When they do, the demand for wool decreases. (iv) If a new high-speed loom is invented, the cost of making wool will fall and the supply of wool will increase. (i) and (iv) If the price of wool rises there is a movement up along the demand curve. The quantity demanded of wool decreases. If a new high-speed loom is invented, the cost of producing wool will fall. So the supply of wool increases. With no change in the demand for wool, the price of wool will fall and there is a movement down along the demand curve for wool. The quantity demanded of wool increases. (i), (ii), and (iii) If the price of wool rises there is a movement up along the supply curve. The quantity supplied of wool increases. If the price of a sweater falls because the supply of sweaters has increased, then the equilibrium quantity of sweaters increases and the demand for wool increases. With no change in the supply of wool, the price of wool rises and the quantity of wool supplied increases. If the price of a sweater falls because the demand for sweaters has decreased, then the equilibrium quantity of sweaters decreases and the demand for wool decreases. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases. If some sweater producers switch to using the new close substitute for wool, the demand for wool will decrease. With no change in the supply of wool, the price of wool falls and the quantity of wool supplied decreases.

The demand curve is the curve that slopes down toward to the right. The supply curve is the curve that slopes up toward to the right.

The equilibrium price is $3 a loaf, and the equilibrium quantity is 100 loaves a day. Market equilibrium is determined at the intersection of the demand curve and supply curve.

The equilibrium price is 80 cents a bag, and the equilibrium quantity is 130 million bags a week.

The price of a bag adjusts until the quantity demanded equals the quantity supplied. At 80 cents a bag, the quantity demanded is 130 million bags a week and the quantity supplied is 130 million bags a week.

At 60 cents a bag, there will be a shortage of potato chips and the price will rise. At 60 cents a bag, the quantity demanded is 150 million bags a week and the quantity supplied is 110 million bags a week. There is a shortage of 40 million bags a week. The price will rise until market equilibrium is restored—80 cents a bag.

There has been a movement along the supply curve. The demand for potato chips decreases, and the demand curve shifts leftward. Supply does not change, so the price falls along the supply curve.

The demand curve has shifted leftward. As the new snack food comes onto the market, the demand for potato chips decreases. There is a new demand schedule, and the demand curve shifts leftward.

The equilibrium price is 60 cents, and the equilibrium quantity is 110 million bags a week. Demand decreases by 40 million bags a week. That is, the quantity demanded at each price decreases by 40 million bags. The quantity demanded at 80 cents is now 90 million bags, and there is a surplus of potato chips. The price falls to 60 cents a bag, at which the quantity supplied equals the quantity demanded (110 million bags a week).

The new price is 70 cents a bag, and the quantity is 100 million bags a week. The supply of potato chips decreases, and the supply curve shifts leftward. The quantity supplied at each price decreases by 20 million bags. The result of the new snack food entering the market is a price of 60 cents a bag.

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At this price, there is now a shortage of potato chips. The price of potato chips will rise until the shortage is eliminated.

Additional Discussion Questions 1.

John Q: Could a legal market for human organ donations have saved his dying son? An opinion piece written by Richard Epstein in The Wall Street Journal (2/21/02) discusses the donation of human organs for transplant operations. He raises the issue that if a market for human donor organs were legal, the dilemma of a lack of organs, as raised by Denzel Washington’s character in the movie “John Q,” might be closer to fiction rather than fact.

You can use this movie and the motive of the main character as an intriguing basis for getting students to construct and interpret the demand and supply model.

Can we illustrate a market for something as vital as organ donations? Begin by asking the students to graph a demand and supply model for the market for human organ donations, making sure that their model reflects the real-life characteristics of this unique market: i) the federal government does not allow individuals or businesses to engage in the buying and selling of human organs, unless the organs are donated and received for free, ii) a small number of organs are donated by living volunteers (like kidney donations) or by the families of the recently deceased (especially after an otherwise healthy individual suffers an accidental death), meaning that the positively sloped supply curve for human organ donations intercepts the quantity axis at some positive value, iii) the demand curve for organs must intercept the supply curve at a positive price.

Are there unintended consequences when market forces are ignored? The government wants to assure that poor people have the same access to available organ transplants as rich people, so it imposes a zero-price restriction on the market. However, this creates a shortage of organs available for transplant, where the quantity of organs demanded at a zero price far exceeds the quantity supplied. If the market for organ donations were unregulated, then the equilibrium price for an organ would surely increase, but so would the total number of people receiving an organ transplant, and presumably, the total number of people who would survive to live another day.

Should society institute a policy that maximizes the numbers of lives saved or manipulates the characteristics of those fewer lives that do get saved? Conclude this discussion with a great set-up for the efficiency versus equity issues developed later in chapter five. Our command of the demand and supply model for human organ donations allows us to discover an important insight into one aspect of health care policy: the government places a lower priority for maximizing the total number of people saved regardless of income, and a higher priority on achieving a “proper” income mix among the smaller number of people that are saved by being one of the few receiving organ transplants.

2.

What are some goods that college students might buy today but will give up when they enter the workforce after graduation? College students usually recognize that they will change their consumption patterns when they are employed after college graduation. Use this to get the students to appreciate inferior goods. When you were an undergraduate, you probably complained about having to eat mostly canned soup or beans as a cheap staple to fill your hungry stomach on a small budget. You swore that when you finally entered the workforce you wouldn’t eat soup or beans again, unless under extreme duress. Today the single food item most frequently cited by students as an inferior good is the Raman style noodles—those dry, thin, near flavorless oriental style noodles that are reconstituted with .

DEMAND AND SUPPLY

37

boiling water. Get the students to create a list other such inferior goods they will avoid when their incomes increase. This gets them to carefully consider how income changes can cause demand curves to shift in an unintuitive manner for an inferior good.

3.

Because computers are cheaper and more abundantly available now than a decade ago, doesn’t this mean the supply curve for computers is downward sloping? This is a real world example for illustrating the confusion between changes in supply and changes in the quantity supplied. (It is easier to analyze this example if the students assume that consumer demand for computer software applications has not changed over the last decade.)

Has anything in the world of computer manufacturing changed over the last decade?

Point out that the observation about falling computer prices with rising quantities sold assumes that nothing significant has changed in the computer industry. Emphasize how such statements reflect how the ceteris paribus condition of careful economic analysis has been violated. Over the years, advances in technology have allowed computer makers to: i) offer greater computer power and versatility for contemporary software applications at the same opportunity cost of resources (market price) as before, or ii) to provide the same level of computer power and versatility for contemporary software applications at lower opportunity costs (market prices) as before. Either way, this represents a rightward shift in the supply curve for computers. The students should recognize that the two prices and two quantities that give the appearance of more computers offered for less are actually from two separate supply curves.

4.

Because the average price of a car has increased substantially over the last 30 years, and the number of cars owned has risen faster than the population, doesn’t this mean that the demand curve for cars is upward sloping? This is a real world example for illustrating the confusion between changes in demand and changes in the quantity demanded. (It is easier to analyze this example if the students assume that automobile production technology has not changed over these last three decades.)

Has anything in the world of consumers changed over the last decade? Point out that this real world observation of car prices and rising quantities sold over time assumes that nothing significant has changed in the consumers’ environment. Emphasize how statements such as these reflect how the ceteris paribus condition of careful economic analysis has been violated. Consumer incomes have increased significantly over the last three decades, allowing them to: i) consume greater personal transportation opportunities for more family members while giving up the same amount of other goods as before, or ii) consume the same level of personal transportation opportunities while giving up less of all other goods as before. Either way, this represents a rightward shift in the demand curve for automobiles. The students should recognize that the two prices and quantities that give the appearance of more automobiles demanded at higher prices are actually from two separate demand curves.

If the status of the family automobile has increased in recent decades, what affect would this have on consumer demand? There is evidence that the proportion of income that typical families spend on automobiles (versus all other goods) has increased substantially over the last 30 years. This means that the percent increase in automobile purchases has been higher than the percent increase in family incomes. This makes for a great lead into the measures of the income elasticity of demand discussed in Chapter 4.

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C h a p t e r

4

ELASTICITY

The Big Picture Where we have been: The student can now use the demand and supply model to generate predictions and can supplement this knowledge with the ability to provide richer predictions based on the elasticities of demand and supply.

Where we are going: Demand, supply, and demand elasticity get an extensive workout in Chapter 6, where we use them to explain the division of a tax burden between buyer and seller and the impact of price controls and quotas. However, before doing that analysis, we study the efficiency and fairness of markets in Chapter 5. Students will also apply elasticity in Chapter 12 to describe demand in perfect competition. In Chapter 13, we study the relationship between total revenue and the price elasticity of demand to show that a monopoly never operates on the inelastic part of the demand curve.

New in the Thirteenth Edition There are only a few minor changes to this chapter. The chapter opening example and the Economics in the News case study focus on using a tax on sugary drinks to address the problem of obesity.

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Lecture Notes

Elasticity • • • •

I.

The price elasticity of demand measures how strongly buyers respond to a change in the price of a good.

The price elasticity of demand can be used to make quantitative predictions of how changes affect the price and quantity demanded of a good.

The income elasticity of demand measures how strongly demanders respond to a change in income, and the cross elasticity of demand measures how strongly demanders respond to the change in the price of another good.

The price elasticity of supply measures how strongly producers respond to a change in the price of a good.

Price Elasticity of Demand •

In general, elasticity measures responsiveness. The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is often useful for both businesses and governments because it can predict the impact of a price change on total revenue or total expenditure.

Calculating Price Elasticity of Demand •

The price elasticity of demand is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of: Percentagechangein quantity demanded .

Percentagechangein price

The formulas for calculating all of the elasticities in the text are based on the arc elasticity or mid-point formula, meaning the percentage changes are always calculated based on the average price (or income in the case of income elasticity) and average quantity over the range of change. If you ask students to calculate elasticities, it is important to practice calculating the percentage change using the average as the basis as it is not likely to be familiar Don’t be afraid to start with this pre-elasticity warm up to assess the sharpness of your class. Ask: “Suppose that the campus bookstore increases the price of an economics text from $75 to $100. What is the percentage increase in price?” Many will say 25 percent. But using the midpoint formula the percentage change is ($25/$87.50) × 100, which is 28.6 percent.

Devise a mnemonic for elasticity calculations. Many students have a hard time remembering whether quantity or price goes in the numerator of the elasticity formulas. Have the students create their own mnemonic. Suggest McDonald’s Quarter Pounder™ hamburgers. It’s silly, but it works, reminding the student that Q (quantity) appears before P (price) in the ratio of percentage changes.

•

•

The demand elasticity formula yields a negative value, because price and quantity move in opposite directions. However, it is the magnitude, or absolute value, of the measure that reveals how responsive the quantity change has been to a price change. So we use the magnitude or the absolute value of the price elasticity of demand.

The table to the right has two points on the Price Quantity demand curve for pizza from a particular pizza (dollars per demanded parlor. pizza) (pizzas per week) • The absolute value of the percent change in 14 500 quantity demanded is 16 400 [(500 − 400)  450]  100 = 22.2 percent. .

ELASTICITY

• •

39

The absolute value of the percentage change in price is [($14 − $16)  $15]  100 = 13.3 percent.

Between these two points on the demand curve, the price elasticity of demand is 22.2%  13.3% = 1.67.

Elasticity is not the same as slope. Students sometimes wonder why we don’t just measure the slope of the demand curve to measure responsiveness. Point out to the students that the slope will change when the units change. For instance, you can compute the slope of a demand curve when the price is measured in dollars and then the slope of the exact same demand curve when the price is measured in cents. The slope with the price measured in cents is 100 times as large as the initial slope. Tell the students that it is not acceptable for the measure of responsiveness to change whenever the units of the price (or of the quantity) change.

Inelastic and Elastic Demand •

• •

•

If the price elasticity of demand is less than 1.0, the good is said to have an inelastic demand. In this case, the percentage change in the quantity demanded is less than the percentage change in price.

• If the quantity demanded remains constant when the price changes, then the good is said to have perfectly inelastic demand. The price elasticity of demand is 0 and the good’s demand curve is a vertical line.

If the price elasticity of demand is equal to 1.0, the good is said to have a unit elastic demand. In this case, the percentage change in the quantity demanded equals the percentage change in price.

If the price elasticity of demand is greater than 1.0, the good is said to have an elastic demand. In this case, the percentage change in the quantity demanded exceeds the percentage change in price.

• If the quantity demanded changes by an infinitely large percentage in response to a tiny price change, then the good is said to have perfectly elastic Furniture 1.26 demand. The price elasticity of demand is infinite.

Motor Vehicles 1.14 The table has some “real-life” elasticities from the book.

Clothing 0.64 Oil

0.05

Economics in Action” Elastic and Inelastic Demand This application shows real-world price elasticities of demand for a variety of goods and services as well as a table with various food elasticities. This data can be a base for discussion of the factors that might lead one item to be more elastic than the other and allow students in real-time to try to explain and apply price elasticity of demand.

Economics in the News: The Elasticity of Demand for Peanut Butter The price elasticity of demand for peanut butter is the basis for this application. Further discussion of other demand elasticities for peanut butter will be explored after those elasticities are introduced.

Elasticity Along a Linear Demand Curve •

•

With the exception of a vertical demand curve and a horizontal demand curve (along which the elasticity is 0 and infinite, respectively) the price elasticity of demand changes when moving along a linear demand curve.

As the figure illustrates, at points on the demand curve above the midpoint, the price elasticity of demand is elastic while at points below the midpoint, the price elasticity of demand is .

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inelastic. At the midpoint, the price elasticity of demand is unit elastic.

Total Revenue and Elasticity •

The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold.

• If demand is elastic, a 1 percent price cut increases the quantity sold by more than 1 percent and total revenue increases.

• If demand is unit elastic, a 1 percent price cut increases the quantity sold by 1 percent and total revenue does not change.

• If demand is inelastic, a 1 percent price cut increases the quantity sold by less than 1 percent and total revenue decreases.

•

The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in price, when all other influences on the quantity sold remain the same.

• If a price cut increases total revenue, demand is elastic. And if a price hike decreases total revenue, demand is elastic.

• If a price cut does not change total revenue, demand is unit elastic. And if a price hike does not change total revenue, demand is unit elastic.

• If a price cut decreases total revenue, demand is inelastic. And if a price hike increases total revenue, demand is inelastic.

Similarly, when a price changes, a consumer’s change in expenditure depends on the consumer’s elasticity of demand.

• If demand is elastic, then a price cut means that expenditure on the item increases.

• If demand is inelastic, then a price cut means that expenditure on the item decreases.

• If demand is unit elastic, then a price cut means that expenditure on the item does not change.

•

How do changes in revenue relate to elasticity mathematically? When demand is elastic, the absolute value of the ratio of the percentage change in quantity demanded to percentage change in price must be greater than one. This point implies that the numerator of the formula for the price elasticity of demand must be greater than the denominator. In that case, the percentage change in quantity demanded is stronger than the percentage change in price, so revenues will change in the same direction as the quantity demanded. On the other hand, if demand is inelastic, the denominator of the formula for the price elasticity of demand must be greater than the numerator. In that case, changes in revenue will change in the same direction as the price because the percentage change in price is stronger than the percentage change in quantity. Reviewing these results also helps students understand the logic for why 1 is the significant value for the coefficient and that the elasticity being farther away from 1 means the reaction is stronger, whether elastic or inelastic.

The Factors that Influence the Elasticity of Demand

The magnitude of the price elasticity of demand depends on: • The closeness of substitutes: The closer and more numerous the substitutes for a good or service, the more elastic the demand. This is critical for understanding demand in the market structure section later in the book.

• The proportion of income spent on the good: The greater the proportion of income spent on a good or service, the more elastic the demand.

• The amount of time elapsed since the price change: The longer the time elapsed since the price change, the more elastic the demand.

Price elasticity of needs versus wants: Necessities, such as food or housing, generally have inelastic demand because there are few substitutes for food and shelter. Luxuries, such as exotic vacations, generally have elastic demand. Example: Most people’s demand for salt is inelastic, largely because most .

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41

people spend a miniscule amount of their income on salt. However large Northern cities’ demand for salt is significantly more elastic. These cities use salt to treat their roads after a snow storm. Salt is a significant fraction of their budgets. Because the proportion of their income they spend on salt is large, the price elasticity of demand for these cities is much larger than that of “ordinary” consumers.

How do gasoline purchases respond to changes in price over time? When gas prices rise from $2 to $4, consumers initially have few options available. At first, with a given car with a given gas mileage, higher gas prices do not reduce the quantity of gas consumers purchase by very much. As time passes and gasoline prices continue to remain high, some consumers eventually find ways to adjust their gas purchases by purchasing more fuel efficient cars, taking new jobs that are closer to their homes, or by taking fewer road trips or car pooling.

II. More Elasticities of Demand Income Elasticity of Demand • •

•

•

The income elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the income, other things remaining the same.

The income elasticity of demand is equal to: Percentagechangein quantity demanded .

Percentagechangein income The changes in the quantity demanded and income are percentages of the average income and quantity demanded over the range of change.

The income elasticity of demand is positive for normal goods and negative for inferior goods.

• If the income elasticity of demand is greater than 1, demand is income elastic and the good is a normal good. As income increases, the percentage of income spent on income elastic goods increases.

• If the income elasticity of demand is positive but less than 1, demand is income inelastic and the good is a normal good. As income increases, the percentage of income spent on income inelastic goods decreases.

Airline Travel 5.82 • If the income elasticity of demand is negative the good is Restaurant Meals 1.61 an inferior good.

Clothing 0.51 The table has some “real-life” income elasticities from the book.

Food 0.14

One of the more common applications for income elasticity of demand that students tend to find interesting is in the stock market. Terms like cyclical, staples, and discretionary sectors are easily explained using income elasticity concepts. Students could consider questions about where in the business cycle a company’s profit might be strongest or weakest and thus more or less worthy of financial investment.

Economies in Action: The Economics in Action shows actual estimates of income and cross price elasticities. Grocery stores and retail stores are a great example of how store scanned data could be used to understand the relationships between products. If a store can put a low margin product on sale and sell more of a high margin product, that is a great use of cross price elasticity data.

Cross Elasticity of Demand •

The cross elasticity of demand is a measure of the responsiveness of the demand for a good to a change in the price of a substitute or complement, other things remaining the same. .

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•

•

The cross elasticity of demand is equal to: Percentagechangein quantity demanded

.

Percentagechangein priceof a substituteor complement The changes in the quantity demanded and the price are percentages of the average price and quantity demanded over the range of change.

The cross elasticity of demand is positive for substitutes and negative for complements.

Examples: Use examples to show the students why the cross elasticity of demand is positive for substitutes and negative for complements. For instance, suppose the price of Coke rises. What effect does this price hike have on the demand for Pepsi? Students will immediately realize that the demand for Pepsi increases. So in this case the cross elasticity of demand for Pepsi with respect to the price of Coke is calculated by dividing one positive number by another, so the result will be positive. (You may need to show the result of a decrease in the price of Cock as well: If the price of Coke falls, the demand for Pepsi will fall, and the cross elasticity of demand for Pepsi with respect to Coke is calculated by dividing a negative percentage change by a negative percentage change, again resulting in a positive number.) Use specific percentage changes to calculate cross price elasticities to emphasize that the sign of the coefficient matters as well as its size. A cross elasticity of 1.5 or .3 are both substitutes but not to the same degree. A cross elasticity of −0.6 or −2.5 are both complements, but again not equally impactful. Explore how knowing cross elasticities might help store managers plan “loss leaders” or how to merchandise products each week.

Some instructors will be more focused on the calculation of the elasticities while others may be more focused on interpreting the elasticity coefficients. For those focused on interpretation, tables with elasticity coefficients could be provided and questions could be framed in terms of the business cycle and how it would change sales of various products at various stores. One store that caters to higher income customers and one store that has bargain basement prices will have different amounts of shelf space devoted to different products. More data would be needed for calculating the elasticities, but students could then create the table and answer the interpretive questions as an class or take home application.

III. Elasticity of Supply • • •

The elasticity of supply measures how responsive producers are to a change in the price of the good.

The elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain unchanged.

Percentagechangein quantity supplied The elasticity of supply is equal to: .

Percentagechangein price

Three Cases of Elasticity of Supply • • •

Supply is perfectly inelastic if the elasticity of supply equals 0. In this case, the supply curve is vertical.

Supply is unit elastic if the elasticity of supply equals 1. In this case, the supply curve is linear and passes through the origin. If any supply curve is linear and passes through the origin, the supply is unit elastic; the slope of the supply curve is irrelevant.

Supply is perfectly elastic if the elasticity of supply is infinite. In this case, the supply curve is horizontal.

Again, elasticity is not the same as slope. The unit-elastic supply curve is a good one to use to emphasize that elasticity and slope are not equal. Have the students calculate the elasticity of supply on two linear demand curves that pass through the origin, one with a slope of 0.5 and the other with a slope of 2.

Regardless of the difference in slope, supply elasticity will be equal to 1. .

ELASTICITY

•

The table to the right has two points on the supply curve for pizza from a particular pizza parlor.

• The percentage change in the Price Quantity supplied quantity supplied is (dollars per (pizzas per week) 28.6 [(400 − 300)  350]  100 = pizza) percent.

14 300 is • The percentage change in price 16 400 13.3 [($16 − $14)  $15]  100 = •

•

43

percent.

Between these two points, the elasticity of supply is 28.6%  13.3% = 2.15.

Supply is elastic if the elasticity of supply exceeds 1.0, unit elastic if the elasticity of supply equals 1.0, and inelastic if the elasticity of supply is less than 1.0.

The Factors that Influence the Elasticity of Supply • •

Resource substitution possibilities: The more unique or rare the resources used to produce the good, the smaller the elasticity of supply. The more common the resources used to produce the good, the larger the elasticity of supply.

The time frame for substitution possibilities: The longer the amount of time producers have to adjust to a change in price, the more elastic the supply will be.

• Momentary supply refers to the period of time immediately following a price change. For some goods, the momentary supply can be perfectly inelastic—fresh fish the day of a price hike. For other goods, the momentary supply can be quite elastic—when the number of telephone calls increases on a holiday, the supply increases with no change in price.

• Short-run supply shows how the quantity supplied responds to a price change when only some of the technological adjustments have been made.

• Long-run supply shows how the quantity supplied responds to a price change when all of the technological adjustments have been made.

Economics in the News: The Elasticity of Demand for Coffee Drop in Global Coffee Prices Shrinks Farmers’ Revenue This feature connects to the chapter opening questions about the price elasticity of demand for coffee. It discusses the global decrease in coffee prices due to increased coffee production and its affect on coffee producer’s income. Additional data are added for the economic analysis.

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Additional Problems 1.

Better-than-average weather brings a bumper tomato crop. The price of tomatoes falls from $6 to $4 a basket, and the quantity demanded increases from 200 to 400 baskets a day. Over this price range, a. What is the price elasticity of demand? b. Describe the demand for tomatoes.

2.

The figure shows the demand for pens. a. Calculate the elasticity of demand for a rise in price from $2 to $4. b. At what prices is the elasticity of demand equal to 1, greater than 1, and less than 1?

3.

If the quantity of fish demanded decreases by 5 percent when the price of fish rises by 10 percent, is the demand for fish elastic, inelastic, or unit elastic?

4.

The table gives the demand schedule for coffee.

Price Quantity demanded a. What happens to total revenue if the price of (dollars per (millions of pounds coffee rises from $10 to $20 per pound? pound) per year) b. What happens to total revenue if the price rises 10 30 to $15 to $25 per pound?

15 25 c. What is the price when total revenue at a 20 20 maximum?

25 15 d. What quantity of coffee will be sold at the price that answers part c? e. At an average price of $15 a pound, is the demand for coffee elastic or inelastic? Use the total revenue test to answer this question.

5.

If a 10 percent fall in the price of beef increases the quantity of beef demanded by 20 percent and decreases the quantity of chicken demanded by 15 percent, calculate the cross elasticity of demand between beef and chicken.

6.

Judy’s income has increased from $10,000 to $12,000. Judy increased her demand for concert tickets by 10 percent and decreased her demand for bus rides by 5 percent.

Calculate Judy’s income elasticity of demand for (a) concert tickets and (b) bus rides.

7.

The table gives the income elasticities of demand for various products. Use it to answer the following questions a. Which product’s demand reacts the most when income changes? b. Which product’s demand increases during a .

Product Haircuts Ramen noodles Tobacco Airline travel

Income elasticity 1.36 −0.76 0.86 5.82

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recession when incomes fall?

8.

The table gives the supply schedule for shoes. Calculate the elasticity of supply when a. The price rises from $125 to $135 a pair. b. The price is $125 a pair.

Price (dollars per pair) 120 125 130 135

Quantity supplied (millions of pairs per year) 1,200 1,400 1,600 1,800

Solutions to Additional Problems 1.

a.

b.

2.

a.

b.

3.

4.

The price elasticity of demand is 1.67. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price falls from $6 to $4 a basket, a fall of $2 a basket. The average price is $5 a basket. So the percentage change in the price equals $2 divided by $5 and then multiplied by 100, which equals 40 percent. The quantity increases from 200 to 400 baskets, an increase of 200 baskets. The average quantity is 300 baskets.

So the percentage change in quantity equals 200 divided by 300 and then multiplied by 100, which equals 66.7 percent. The price elasticity of demand for tomatoes equals 66.7 percent divided by 40 percent, which is 1.67.

The price elasticity of demand exceeds 1, so the demand for tomatoes is elastic.

The price elasticity of demand is 0.33. When the price of a pen rises from $2 to $4, the quantity demanded of pens decreases from 100 to 80 a day. The price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in the price. The price increases from $2 to $4, an increase of $2 a pen. The average price is $3 a pen. So the percentage change in the price equals $2 divided by $3 and then multiplied by 100, which equals 66.7 percent. The quantity decreases from 100 to 80 pens, a decrease of 20 pens. The average quantity is 90 pens. So the percentage change in quantity equals 20 divided by 90 and then multiplied by 100, which equals 22 percent. The price elasticity of demand for pens equals 22 percent divided by 66.7 percent, which is 0.33.

The price elasticity of demand equals 1 at $6 a pen. The price elasticity of demand is greater than 1 at prices greater than $6 a pen. The price elasticity of demand is less than 1 at prices less than $6 a pen. The price elasticity of demand equals 1 at the price halfway between the origin and the price at which the demand curve hits the y-axis. That price is $6 a pen. The demand curve is linear. Along a linear demand curve, the price elasticity of demand is greater than 1 at points above the midpoint and less than 1 at points below the midpoint. The price elasticity of demand is greater than 1 at prices above $6 a pen and less than 1 at prices below $6 a pen.

The demand for fish is inelastic. The price elasticity of demand for fish equals the percentage change in the quantity of fish demanded divided by the percentage change in the price of fish. The price elasticity of demand equals 5 percent divided by 10 percent, which is 0.5. The demand is inelastic.

a.

Total revenue increases. When the price of a pound of coffee is $10, 30 million pounds are sold and total revenue equals $300 million. When the price of a pound of coffee rises to $20, 20 million pounds are sold and total revenue is $400 million. Total revenue increases.

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b.

c.

d. e.

Total revenue does not change. When the price of a pound of coffee is $15, 25 million pounds are sold and total revenue is $375 million. When the price of a pound of coffee is $25, 15 million pounds are sold and total revenue is $375 million. Total revenue does not change.

Total revenue is maximized at $20 a pound. When the price of a pound of coffee is $20, 20 million pounds are sold and total revenue equals $400 million. When the price is $15 a pound, 25 million pounds are sold and total revenue equals $375 million. Total revenue increases as the price rises from $15 to $20 a pound. When the price is $25 a pound, 15 million pounds are sold and total revenue equals $375 million. Total revenue decreases as the price rises from $20 to $25 a pound.

Total revenue is maximized when the price is $20 a pound.

The quantity will be 20 million pounds a year. The demand schedule tells us that when the price is $20 a pound, the quantity of coffee demanded is 20 million pounds a year.

The demand for coffee inelastic. The total revenue test says that if the price rises and total revenue increases, the demand is inelastic at the average price. For an average price of $15 a pound, raise the price from $10 to $20 a pound. When the price of a pound rises from $10 to $20, total revenue increases from $300 million to $400 million. So at the average price of $15 a pound, demand is inelastic.

5.

The cross elasticity of demand between beef and chicken is 2. The cross elasticity of demand is the percentage change in the quantity demanded of one good divided by the percentage change in the price of another good. The fall in the price of beef resulted in a decrease in the quantity demanded of chicken. So the cross elasticity of demand is the percentage change in the quantity demanded of chicken divided by the percentage change in the price of beef. The cross elasticity equals 20 percent divided by 10 percent, which is 2.

6.

Income elasticity of demand for (a) concert tickets is 0.55 and (b) bus rides is −0.275. Income elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in income. The change in income is $2,000 and the average income is $11,000, so the percentage change in income equals 18.2 percent. a. The change in the quantity demanded of concert tickets is 10 percent. The income elasticity of demand for concert tickets equals 10/18.2, which is 0.55. b. The change in the quantity demanded of bus rides is −5 percent. The income elasticity of demand for bus rides equals −5/18.2, which is −0.275. a. The income elasticity of demand for airline travel is the largest in magnitude, so the demand for airline travel changes the most when income changes. b. The income elasticity of demand for Ramen noodles is negative, so its demand will increase when income falls in a recession. a. The elasticity of supply is 3.25. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. When the price rises from $125 to $135, the change in the price is $10 and the average price is $130. The percentage change in the price is 7.7 percent. When the price rises from $125 to $135, the quantity supplied increases from 1,400 million to 1,800 million pairs. The change in the quantity supplied is 400 million pairs, and the average quantity is 1,600 million pairs, so the percentage change in the quantity supplied is 25 percent. The elasticity of supply equals (25 percent)/(7.7 percent), which equals 3.25. b. The elasticity of supply is 3.57. The formula for the elasticity of supply calculates the elasticity at the average price. So to find the elasticity of supply at $125, change the price such that $125 is the average price—for example, a fall in the price from $130 to $120. When the price falls from $130 to $120, the change in the price is $10 and the average price is $125. The percentage change in the price is 8 percent. When the price falls from $130 to $120, the quantity supplied decreases from 1,600 million to 1,200 million pairs. The change in the quantity supplied is 400 million pairs and

7.

8.

.

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the average quantity is 1,400 million pairs. The percentage change in the quantity supplied is 28.57 percent. The elasticity of supply is the percentage change in the quantity supplied divided by the percentage change in the price. The elasticity of supply is 3.57.

Additional Discussion Questions 1.

How does inelastic student demand for parking hinder police efforts at preventing illegal student parking? Illegal student parking is a hassle that every university police force must deal with. Ask the students whether the campus police will have more success with doubling the current parking fine, or liberally using the “boot,” which is a heavy iron clamp locked to the wheel of a car, rendering it immobile. Students will understand that raising the parking ticket fees is simply raising the price for illegal parking, and if quantity demanded does not decrease very much, demand for those choice parking spots is inelastic.

To significantly decrease the incidence of illegal parking, the price must be raised substantially. Having their personal transportation severely restricted with a boot for a period of time is a much higher “price” with a more effective result.

2.

How inelastic is the demand for gasoline and how inelastic is the supply? How might this explain sharp price fluctuations in the market for gasoline? Students recognize that there are few good substitutes for gasoline. Ask them if they think the demand for gas is relatively elastic or inelastic. They’ll likely say that demand for gasoline is relatively inelastic. Point out that although there are some substitutes for gasoline (riding the bus, riding a bicycle, or walking), those options are not necessarily easy to substitute for driving a gas-powered vehicle. Discuss whether firms have the ability to bring more gas to the market in a short run time frame. If quantity does not adjust much when demand or supply change, price is likely to fluctuate greatly.

3.

If the demand for gasoline is relatively inelastic, why does Joe’s Quick-Mart lose a lot of business when he raises his gas prices? Ask your students if Joe’s Quick-Mart (substitute your actual local one) convenience store would lose much business if Joe raised the price of gasoline more than a penny or two compared to the other three gas stations at the same street intersection. When the students conclude he’d lose much of his gasoline sales, point out that this would imply that the demand for gas at Joe’s is relatively elastic, not inelastic.

(If an increase in price results in a decrease in revenues, demand is elastic.) Ask them to reconcile the two results. How can demand for gasoline be inelastic when demand for gasoline at Joe’s is elastic? Their response should be that because other stations offer gasoline that is a good substitute for gasoline at Joe’s, demand for gasoline at Joe’s will be more elastic than the demand for gasoline overall. If all gas stations at the intersection raised their prices by a penny or two, the reduction in quantity demanded would be much smaller.

4.

How can knowing price elasticities of demand help student government and university officials set prices for campus events? Paying for programs in an increasingly tighter budget era makes pricing decisions even more critical. Lower prices bring in more revenue if demand is elastic. Higher prices bring in more revenue if demand is inelastic.

5.

How can the owner of The Burger Barn determine if a one-day promotional sale on milkshakes will affect the total revenues generated by hamburger sales? This question will exercise student knowledge of cross elasticities. First, the students need to assume that the price of burgers remains unchanged. Next, the students need to determine whether the cross elasticity is positive (substitutes) or negative (complements). If burgers and .

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milkshakes are substitutes, then burger revenues will decrease during the sale. However, if burgers and milkshakes are complements, then burger revenues will increase.

6.

Is the demand for higher education income elastic, income inelastic or inferior?

Enrollments in many institutes of higher education rose during the economic downturn, although demand for community college education may have increased the most dramatically and some institutions did see declines in enrollment. Ask students to discuss how income changes have and could affect enrollment choices and demands for financial aid programs and products.

7.

How does price elasticity of supply explain shortages of vaccinations for H1N1 in the 2009-2010 school year and its wide availability as part of the standard seasonal flu vaccination in subsequent school years? The difficulty involved and changes in resources needed to launch a new vaccine meant priority lists and lack of availability in many places as the threat of H1N1 was identified. A year later, the vaccination was incorporated into the standard seasonal flu shot and everyone was encouraged to get protected.

8.

How might knowledge of the elasticity of supply for antibiotics be important for the government’s ability to respond to potential chemical and biological attacks? In the ensuing months after the terrorist attacks, security concerns in the United States were heightened when rumors and further proclamations of pending chemical and biological attacks on the United States were reported in the media. Ask the students if it would be important for the government to know what the elasticity of supply would be for superstrength antibiotic medicines (like the popularized medicine Ciprofloxacin) available on the world market. They should consider how easy or how difficult it would be for producers to respond to an increase in demand (and increase in the equilibrium price) for Cipro.

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C h a p t e r

5

EFFICIENCY AND EQUITY

The Big Picture Where we have been: This chapter develops a more thorough understanding of efficiency, which was first introduced in Chapter 2. It also develops a deeper grasp of how the demand and supply model introduced in Chapter 3 influences resource allocations in an economy. Finally, it explains the situations in which a competitive market does and does not allocate resources efficiently.

Where we are going: Chapter 6 applies the concepts of efficiency and deadweight loss to market regulation policies such as rent ceilings and minimum wage laws. Students should understand these concepts well to appreciate applying demand and supply to important markets in our economic world. Chapter 7 then applies the same concepts to issues surrounding international trade and government protectionist policies. The concepts of efficiency and deadweight loss recur in Chapters 12, 13, and 14, which examine perfect competition, monopoly, monopolistic competition, and regulation. The same efficiency concepts are also used in Chapters 16 and 17, which cover social issues such as public goods and externalities.

New in the Thirteenth Edition

The chapter opener still examines traffic and driving choices, but the article used for the Economics in the News application at the end of the chapter has been updated and has more data about the costs of congestion. The analysis still focuses on using congestion charges to improve efficiency.

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EFFICIENCY AND EQUITY

Lecture Notes

Efficiency and Equity • • •

I.

Using prices in markets to allocate scarce resources is one of many alternative methods of allocating scarce resources.

Tools such as consumer surplus and producer surplus help evaluate efficiency.

The outcomes from the various methods used to allocate scarce resources, especially markets, can be examined in terms of both their efficiency and fairness.

Resource Allocation Methods

Resources are scarce, so they somehow must be allocated. Different methods of allocating resources include: • Market price: The people who are willing and able to buy a resource get the resource.

• Command: a command system allocates resources by the order (command) of someone in authority. A command system works well in organizations with clear lines of authority but does not work well at allocating resources in the entire economy.

• Majority rule: resources are allocated in accordance with majority vote. Majority rule works well when the allocation decisions being made affect a large number of people and self-interest leads to bad decisions.

• Contest: resources are allocated to the winner. Contests work well when the efforts of the players are hard to measure, such as top managers being in a contest to be named CEO of a company.

• First-come, first-serve: resources are allocated to those who are first in line. This allocation method works well when the resource can serve just one user at a time in a sequence, as is the case with, say, a bank teller or an ATM. • Lottery: resources are allocated to the people who pick the winning number, choose the lucky card, etc. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource.

• Personal characteristics: resources are allocated to people with the “right” characteristics.

• Force: resources are allocated to those who can forcibly take the resources.

Is allocating goods to those willing and able to pay higher prices fundamentally unfair? Students often believe that allocating resources using market prices is somehow unfair. The first section of this chapter, which discusses different ways of allocating resources, and the discussion in the last section of the chapter about the fairness of these different methods in a situation with a shortage, will help open students’ eyes to the fact that somehow resources must be allocated and using the market price has many desirable characteristics that are perhaps often overlooked. In particular, using market prices to allocate goods and services means that goods and services are sold to people who can afford them and want to buy them. Students often focus on the first part—“afford”—and ignore the second part—“want to buy.” Clearly wealthy people can better afford to buy goods and services. But this does not mean that the wealthy buy everything. For instance, it is likely the case that your cell phone is less advanced in features and service plans than cell phones owned by your students. You perhaps can better afford these phones than your students, but you simply may not want the newest, most wired smart device as much as they do. So using market prices means that people who most strongly want the newest and greatest smart phone will acquire it … at least as long as they can afford it. Other resource allocation methods generally do not take account of how strongly someone wants a good or service. As a result, other methods of allocation can allocate goods and services to people who may not value them the most.

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EFFICIENCY AND EQUITY

51

II. Benefit, Cost, and Surplus Demand, Willingness to Pay, and Value •

•

The value of one more unit of a good or service is its marginal benefit. Marginal benefit is the maximum price that people are willing to pay for another unit of a good or service. And the willingness to pay for a good or service determines the demand for it. Consequently the demand curve for a good or service is also its marginal benefit curve.

The market demand curve is the horizontal sum of the individual demand curves and is formed by adding the quantities demanded by all the individuals at each price.

How do you add “horizontally”? Students sometimes have trouble with the concept of adding individual demand curves “horizontally.” Emphasize that the quantity demanded is measured on the “horizontal” axis, so we’re simply adding together all the individual quantities demanded to get the market quantity demanded at a particular price.

•

•

•

The demand curve in the figure shows that the maximum price a person is willing to pay for the 6 millionth gallon of milk per month is $3, so $3 is the marginal benefit of this gallon.

MSB curve: In the absence of externalities, which will be discussed later, the market demand curve is also the economy’s marginal social benefit (MSB) curve. It reflects the number of dollars’ worth of other goods and services willingly given up to obtain one more unit of a good.

• The figure shows that the maximum price a consumer is willing and able to pay for the 6 millionth gallon of milk is $3, so the marginal social benefit of the 6 millionth gallon of milk is $3.

Consumer surplus is the value (or marginal benefit) of the good minus the price paid for it, summed over the quantity bought. The figure illustrates the consumer surplus as the shaded triangle when the price is $3 per gallon.

The negative slope of demand and declining marginal benefit. Marginal benefit is the maximum price people are willing to pay for one more unit of a good or service. Because willingness to pay determines demand, a demand curve is a marginal benefit curve. Demand curves have a negative slope because, as the price rises, the quantity demanded falls. The negative slope of the demand curve can also be explained by the concept of declining marginal benefit. The more you already have of a good, the less valuable an additional unit of that good is to you. In other words, the maximum price you are willing to pay for another unit of that good (its marginal benefit) declines as the quantity you have increases.

Consumer surplus graphically is the area under the demand curve and above the price. One thing that students sometimes get hung up on is the exact shape of the consumer surplus area, in particular the steps of consumer surplus for discrete units versus the complete triangle. The point isn’t worth laboring, but if students raise the matter and are curious, you might explain that we’re assuming that the good is finely divisible so that the whole triangle is (approximately) the consumer surplus.

Low prices are great for consumers. Students know that low prices are better for consumers than high prices. But consumer surplus gives them a way to demonstrate this basic idea. Take a minute to evaluate .

EFFICIENCY AND EQUITY

the change in consumer surplus from a given change in price. The big impact is not the marginal increase in the number of units purchased, but the increase or decrease in consumer surplus of the units that are still being purchased regardless of the change in price. The area of consumer surplus will become smaller when prices rise and larger when prices fall. This quantifies graphically something students intrinsically know: from the point of view of consumers, low prices are good and high prices are bad. The best example for most people is their strong irritation when gas prices rise and their perception of well being when gas prices fall. Even if they do not change the amount of gas they buy at all, they perceive the change in their consumer surplus.

Supply, Cost, and Minimum Supply-Price •

The cost of producing one more unit of a good or service is its marginal cost. Marginal cost is the minimum price that producers must receive to induce them to produce another unit of the good or service. And the minimum acceptable price determines the quantity supplied. Consequently the supply curve for a good or service is also its marginal cost curve.

The positive slope of supply and increasing marginal cost. The fact that supply curves have a positive slope implies that the marginal cost of production increases as the level of production expands. You can refer back to increasing opportunity costs to reinforce this idea for your students. As producers increase production, they will need to increase the amount of resources they use. Initially, firms use the cheapest resources possible (labor that has comparative advantage in producing the good, for example). As output expands, however, additional resources will become increasingly costly (as labor that does not have a comparative advantage in production is used in the production process). If resource costs are rising as the quantity of output supplied increases, the minimum price producers must receive to induce them to produce more will also increase.

• •

•

The market supply curve is the horizontal sum of the individual supply curves and is formed by adding the quantities supplied by all the producers at each price.

MSC curve: In the absence of externalities, the market supply curve is the economy’s marginal social cost (MSC) curve.

• The supply curve in the figure shows that the minimum price a producer must receive to be willing to produce the 6 millionth gallon of milk per month is $3, so $3 is the marginal social cost of this gallon.

Producer surplus is the price of a good minus its minimum supply-price (or marginal cost), summed over the quantity sold. The figure illustrates the producer surplus as the shaded triangle when the price is $3 per gallon.

Producer surplus graphically is the area above the supply curve and below the price line. Every unit that adds more to revenue than it does to cost adds to producer surplus. Point out how increases in price expand producer surplus and how decreases in price reduce it. From producers’ point of view, high prices are better, something that often confuses students who are used to thinking of price as cost not as revenue. This is a good moment to reinforce that difference. .

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Is producer surplus the same as profit? At this point in the course, students don’t have all the tools necessary to understand the difference so it is perhaps best to simply say they aren’t exactly the same, and that firms will sometimes find it in their best interests to produce for a time even if they are losing money.

Promise to explore profit and profit-maximization more in future chapters. If students are persistent you can explain that producer surplus equals total revenue minus total variable cost, while economic profit equals total revenue minus total cost. That means producer surplus isn’t exactly economic profit. Rather, producer surplus equals economic profit plus total fixed cost. Don’t spend much time discussing this point now, but be ready for it if you get such a question when you’re in Chapters 12, 13, or 14.

III. Is the Competitive Market Efficient?

Efficiency of Competitive Equilibrium •

•

•

•

The marginal benefit to the entire society is the marginal social benefit curve, MSB. If all the benefits from consuming a good go to its consumers, the market demand curve is the same as the MSB curve.

The marginal cost to the entire society is the marginal social cost curve, MSC. If all the costs of producing a good are paid by the producers, the market supply curve is the same as the MSC curve.

When the marginal social benefit of the last unit produced equals its marginal social cost, society attains efficiency. However, because the demand curve is the same as the MSB curve and the supply curve is the same as the MSC curve, the efficient quantity that sets the MSB equal to the MSC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. The figure illustrates how the efficient quantity of milk, 6 million gallons per month, also is the equilibrium quantity of milk.

When the efficient quantity of milk is produced, the sum of the consumer surplus and producer surplus (total surplus) is maximized.

It helps to summarize all the results of efficiency at this point, as follows: • By definition, efficiency requires that resources are being used where they are most highly valued.

• When resources are used where they are most highly valued, MSB = MSC. • When the demand and supply curves intersect, QD = QS, and the market achieves equilibrium.

• At equilibrium the total surplus in the market is maximized. (This is usually the most difficult concept to prove without use of calculus in principles courses. Be sure to emphasize to your students that the following sections and chapters will show exactly what happens to consumer and producer surplus when the market moves away from equilibrium.)

• Buyers and sellers acting in their own self-interest maximize social well-being.

• Adam Smith, in his 1776 book The Wealth of Nations, articulated how competition led selfinterested consumers and producers to make choices that unintentionally promote the social interest as if they were led by an “invisible hand.

Economics in Action: Selling the Invisible Hand This case discusses how the Invisible hand of the market allocates resources to their highest valued use first with a cartoon and then in a real-life case of pizza delivery. .

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The Invisible Hand at work: When demand or supply shifts in a market, equilibrium changes to a new point where the MSB = MSC, as reflected in the new demand or supply curve. Show students how an increase in demand, for example, increases the MSB of every unit of output and results in a new, higher level of output that achieves efficiency. A decrease in supply raises the MSC of every unit, and with fewer units available, the MSB of those units is greater. The resulting decrease in output from the change in supply achieves efficiency.

For students who want more information: Although done simply with words and a graph, this section explains the so-called “first fundamental theorem of welfare economics” that, under appropriate conditions, the competitive equilibrium is Pareto efficient (what this textbook calls an “efficient allocation”). You can extend Adam Smith’s “invisible hand” conjecture with mention of Vilfredo Pareto (1848–1923), an Italian economist who defined an efficient allocation as one in which it is not possible to rearrange the use of resources and make someone better off without making someone else worse off. But Adam Smith’s conjecture did not receive formal proof until the 1950s. John Hicks, Kenneth Arrow, and Gerard Debreu are credited with the major contributions to welfare economics and received the Nobel Prize in Economic Sciences. (http://www.nobel.se/economics/laureates/1972/index.html, http://www.nobel.se/economics/laureates/1983/index.html). Lionel McKenzie (University of Rochester) is also credited with a major independent statement of the theorem and some economists refer to it as the Arrow-Debreu-McKenzie theorem. The A-D-M proof is deeper and more restricted than the words and diagrams of a principles text. But we do not mislead our students by being enthusiastic and amazed at the astonishing proposition. Selfish people all pursuing their own ends and making themselves as well off as possible end up allocating resources in such a way that no one can be made better off (qualified by the exceptions that we quickly note in the chapter.)

Market Failure • •

Inefficiency can occur because either too little of an item is produced (underproduction) or too much is produced (overproduction).

In either case, a deadweight loss occurs. A deadweight loss is the decrease in the consumer surplus and producer surplus (decrease in total surplus) that results from producing at an inefficient level of production.

The figure illustrates the deadweight loss from overproduction of milk and from underproduction.

What is deadweight loss intuitively? In the figure above, production of the 4 millionth gallon of milk results in a MSB of $4 and a MSC of $2. By stopping production at 4 million gallons, society is losing that extra $2 of benefit relative to cost. In fact, the MSB will be greater than MSC for all production less than 6 million gallons. That lost value to society is deadweight loss. Similarly, production of the 8 millionth gallon of milk results in a MSB of $2 and a MSC of $4. In this case, the resources used to produce any milk beyond the 6 millionth gallon impose an additional cost that is greater than its additional benefit. In other words, resources would have a higher value elsewhere (in their best alternative use) than their use in the production of milk. That lost value to society again is deadweight loss.

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Sources of Market Failure

Sometimes a market overproduces or underproduces a good or service. The key obstacles to achieving an efficient allocation of resources in a market are: • Price and Quantity Regulations: A price ceiling sets the highest legal price and a price floor sets the lowest legal price. If a price ceiling or price floor makes the equilibrium price illegal, it can lead to inefficiency. Quantity regulations that limit the amount produced also lead to inefficiency. (Studied in Chapter 6) • Taxes and Subsidies: Taxes and subsidies place a wedge between the prices consumers pay and the prices producers receive. Both can lead to inefficiency. (Studied in Chapter 6) • Externalities: An externality is a cost or a benefit that affects someone other than the seller or the buyer. In that case, the demand curve is not the same as the marginal social benefit curve and/or the supply curve is not the same as the marginal social cost curve. In these cases, inefficiency results. (Studied in Chapter 16) • Public Goods and Common Resources: A public good is a good or service that is consumed simultaneously by everyone even if they don’t pay for it. Public goods lead to a free-rider problem, in which people do not pay for their share of the good. A common resource is owned by no one but available to be used by everyone. Common resources are generally over-used because no one owns the resource. In both cases, inefficiency can occur. (Studied in Chapter 17) • Monopoly: A monopoly is a firm that has sole control of a market. To maximize its profit, a monopoly produces less than the efficient quantity and so creates inefficiency. (Studied in Chapter 13) • High transactions costs: The opportunity costs of making a trade are transactions costs. When these costs are high, a market might underproduce because too few transactions take place.

Alternatives to the Market

If markets do not allocate resources efficiently, then one of the alternatives might do a better job. For instance, using first-come, first-serve to allocate spaces in a line at a movie theater probably works better than a market.

IV. Is the Competitive Market Fair?

• •

Efficiency is a positive term, while equity is a normative term. Not everyone can agree upon what is fair.

There are two general ways of defining fairness: “It’s not fair if the results aren’t fair” and “It’s not fair if the rules aren’t fair.”

It’s Not Fair If the Result Isn’t Fair •

Utilitarianism adopts this view. Utilitarianism is a principle that states that we should strive to achieve “the greatest happiness for the greatest number.” This principle argues that fairness requires equality of incomes, which requires that incomes be redistributed.

Numerical example: If Lawrence makes $50,000 per year and Sylvia makes $60,000, then the marginal benefit of an additional dollar is greater for Lawrence than for Sylvia. Let’s say the marginal benefit of an additional dollar to Lawrence is equal to 8 units of “happiness,” while the marginal benefit of an additional dollar to Sylvia is only 3 units of happiness. (You may want to introduce the concept of “utility” as the economist’s proxy for “happiness.” The concept of utility will be more fully developed in Chapter 8.) If $1 of income is transferred from Sylvia to Lawrence, Sylvia will lose 3 units of happiness, but Lawrence will gain 8 units of happiness. Although Sylvia is worse off individually, the overall level of “happiness” in the economy has increased by 5 units. This process of transferring income from Sylvia to Lawrence can be repeated as long as Sylvia’s marginal benefit of an additional dollar is still less than Lawrence’s marginal benefit of an additional dollar.

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• •

Redistribution leads to the big tradeoff, the tradeoff between efficiency and fairness. The tradeoff occurs because taxes decrease people’s incentives to work, thereby decreasing the size of the “economic pie.” In addition, taxes lead to administration costs that also decrease the economic pie.

John Rawls argued that redistribution should strive to make the poorest as well off as possible which may mean a smaller piece of a bigger pie, rather than an equal piece, to keep incentives in place.

It’s Not Fair If the Rules Aren’t Fair •

This perspective relies on the symmetry principle—the requirement that people in similar situations should be treated similarly. In economics, this means equality of economic opportunity rather than equality of economic outcomes.

• Robert Nozick suggests government should promote fairness by establishing property rights for individuals and allowing only voluntary exchange of these resources.

• If private property rights are enforced, if voluntary exchange takes place in a competitive market, and if none of the obstacles to efficiency listed before exist, then according to Nozick, the competitive market is fair.

What’s a “fair” grade in this class? Students generally expect to be graded based on their performance in a class. This scheme is a “fair rules” view of fairness. Discuss this observation with the class, and then ask if it would be fairer to grant everyone an A—a “fair results” view. Many students (especially ones who wouldn’t usually expect an A in a course) will find the guarantee of an A for everyone completely “fair.”

Other students who know they work hard for their grades are likely to say this is “unfair.” Ask the question again, but this time consider automatically giving every student a D—or even an F. Would this be fair?

Most students would agree that automatically failing everyone would not be “fair.” If automatically giving students an A is fair, why isn’t it equally fair to automatically give each student an F? Or, suppose on the final day of class, the rules of the course are changed so that regardless of a student’s previous scores, the student will be given an A—is this change fair? What if the student was automatically given an F—is this change fair? Focus again on what’s a fair “result” as opposed to a fair “rule.”

At Issue: Price Gouging This section considers the case of Price Gouging. The legal argument and the economist’s counter argument are considered in light of a case against selling generators at twice the normal price in the aftermath of Hurricane Katrina.

Economics in the News: Making Traffic Flow Efficiently Solving Traffic Congestion Recent research on how to make traffic flow more efficiently has shown the benefit of adding capacity is only temporary. Traffic expands to the natural rate of high congestion. Mass transit projects somewhat astoundingly do not reduce traffic. What does reduce traffic is congestion pricing, charging a (higher) price for driving in congested areas or at congested times.

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Additional Problems 1.

The table gives the demand and Quantity Quantity supply schedules for spring Price demanded supplied water. (dollars per bottle) (bottles per day) a. What is the maximum price that consumers are willing to 0 80 0 pay for the 30th bottle?

0.50 70 10 1.00 60 20 b. What is the minimum price 1.50 50 30 that producers are willing to 2.00 40 40 accept for the 30th bottle?

2.50 30 50 c. Are 30 bottles a day less than 3.00 20 60 or greater than the efficient 3.50 10 70 quantity?

4.00 0 80 d. What is the consumer surplus if the efficient quantity of spring water is produced? e. What is the producer surplus if the efficient quantity is of spring water is produced? f. What is the deadweight loss if 30 bottles are produced?

2.

The table gives the demand schedules for train travel for Joe, Jean, and Joy. a. If the price of train travel is Price Quantity demanded 50 cents a passenger mile, (cents (passenger miles) what is the consumer surplus per mile) Joe Jean of each consumer?

10 50 600 b. Which consumer has the 20 45 500 largest consumer surplus?

30 40 400 Explain why.

40 35 300 c. If the price of train travel falls 50 30 200 to 30 cents a passenger mile, 60 25 100 what is the change in 70 20 0 consumer surplus of each 80 15 0 consumer?

90 10 0 100 5 0 110 0 0

Joy 300 250 200 150 100 50 0 0 0 0 0

Solutions to Additional Problems 1.

a.

b.

c.

The maximum price that consumers will pay is $2.50. The demand schedule shows the maximum price that consumers will pay for each bottle of spring water. The maximum price that consumers will pay for the 30th bottle is $2.50.

The minimum price that producers will accept is $1.50. The supply schedule shows the minimum price that producers will accept for each bottle of spring water. The minimum price that produces will accept for the 30th bottle is $1.50.

30 bottles is less than the efficient quantity. The efficient quantity is such that marginal benefit from the last bottle equals the marginal cost of producing it. The efficient quantity is the equilibrium quantity—40 bottles a day. .

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d.

e. f.

2.

a.

b. c.

Consumer surplus is $40. The equilibrium price is $2. The consumer surplus is the area of the triangle under the demand curve above the price. The area of the triangle is ½  ($4 − $2)  40, which is $40.

Producer surplus is $40. The producer surplus is the area of the triangle above the supply curve below the price. The price is $2. The area of the triangle is ½  ($2 − $0)  40, which is $40.

The deadweight loss is $5. Deadweight loss is the sum of the consumer surplus and producer surplus that is lost because the quantity produced is not the efficient quantity. The deadweight loss equals ½  (40 − 30)  ($2.50 − $0.50), which is $5.

Joe’s consumer surplus is $9. Jean’s consumer surplus is $20, and Joy’s consumer surplus is $10.

Consumer surplus is the area under the demand curve above the price. At 50 cents, Joe will travel 30 miles, Jean will travel 200 miles, and Joy will travel 100 miles. Joe’s consumer surplus equals ½  (110¢ − 50¢)  30, which equals $9. Similarly, Jean’s consumer surplus equals ½  (70¢ − 50¢)  200, which equals $20. And Joy’s consumer surplus equals ½  (70¢ − 50¢)  100, which equals $10.

Jean’s consumer surplus is the largest because she places a higher value on each unit of the good than the other two do.

Joe’s consumer surplus rises by $7. Jean’s consumer surplus rises by $60, and Joy’s consumer surplus rises by $30. At 30 cents a mile, Joe travels 40 miles and his consumer surplus is $16. Joe’s consumer surplus equals ½  (110¢ − 30¢)  40, which equals $16. Joe’s consumer surplus increases from $9 to $16, an increase of $7. Jean travels 400 miles and her consumer surplus is $80, an increase of $60. Joy travels 200 miles and her consumer surplus is $40, an increase of $30.

Additional Discussion Questions 1.

Do price controls help following a natural disaster or emergency? The text introduces the compelling dilemma of allocating necessary goods following a natural disaster. (Though this issue is serious, if you want a few laughs—and perhaps more student engagement—use the idea of a Zombie disaster as your example.) Engage the students in a careful discussion on this theme, as it opens their eyes to the complexities involved with trying to improve upon the competitive market allocation of scarce resources, even under times of economic duress.

• Should “price gouging” and “profiteering” be considered criminal acts? Price controls are often imposed for weeks after the devastating event occurs. Goods such as bottled drinking water, bags of ice, batteries, electrical generators, plywood sheets (to seal broken windows), and chain saws (to remove downed trees from roadways) are typical objects for which sellers are not allowed to raise their sale price above predisaster levels. Ask students to critically examine the claim that such price restrictions protect the interests of disaster victims who are trying to get their lives back to normal as quickly as possible.

• What happens to the demand curve for these goods? Ask the students to use the supply and demand model to reflect changes in the market for these goods immediately after the disaster has struck. Clearly the radical change in the local environment causes a rightward shift in the demand curve, sharply raising equilibrium market price. A price ceiling results in a heart-wrenching shortage.

• What happens to the supply curve for these goods? Emphasize that the devastation that creates trauma for the consumers also significantly increases the cost of replacing the goods sold in a timely fashion. Replacement of these items needs to be rather quick if the victims want to minimize any future damage to the community (continued water .

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•

•

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damage from damaged homes, illnesses from contaminated drinking water supplies, etc.). The increase in the opportunity cost of supplying these goods pushes the supply curve to the left, aggravating the shortage. Motivate the students to consider how the goods will ultimately be distributed.

Distribution under price regulation: There is much pain, but is there any gain (in efficiency or in fairness)? Often the government sets and enforces price controls for these goods after a disaster. Point out to students that in an unregulated market, only those victims who value the goods at least as much as the unregulated equilibrium price would receive the scarce goods. Under price controls, it is uncertain how the goods will be allocated. Consumers with relatively low valuation of the goods are just as likely end up with the goods as those who have a relatively high valuation, decreasing total consumer surplus. Also, point out that if private resale prices are not closely monitored, then those victims with a relatively low value for their goods would engage in arbitrage by selling the goods at a high price to victims with a relatively high valuation for the goods. This simply transfers producer surplus from sellers to low valuation consumers, the fairness of which would be difficult to justify.

Can price regulation contribute to undesirable seller behavior? Since the price control erases the opportunity cost that suppliers would normally face if they fail to sell their scarce goods to the highest bidder, these sellers may consider any number of nonmonetary benefits when they determine who will ultimately receive their goods: Friends and well-networked acquaintances of the suppliers will likely receive consideration over strangers who would otherwise be willing to pay a higher price. In other words, sellers can use a personal characteristics method of allocation, so they might practice racial, gender, or religious discrimination when selling their goods.

Can price regulation actually prolong victims’ suffering? Point out that for suppliers to quickly replace their depleted inventory they must be willing to bid away the goods from other areas not devastated by the disaster. Also, special deliveries of these goods to the disaster area must be arranged, meaning transportation resources must also be bid away from their usual employment. Both realities increase the cost of inventory replacement. Under a price ceiling there is insufficient incentive for goods to be quickly redistributed to where they are needed the most.

2.

The big tradeoff: How can economic analysis make us more informed citizen voters?

How to properly address the big tradeoff in society is the heart of continuing debates over proposed changes to the federal income tax code.

• Should tax rates be decreased in order to spur greater economic activity and increase total production of goods and services in the economy? Get the students to identify and describe the opportunity cost of this proposal. Would income inequality increase? Would the “social fabric” change?

• Should tax rates be increased to reduce the federal budget deficit and outstanding, national debt, or to fund greater government services and income redistribution programs? This chapter has shown that the economic pie would decrease if income were redistributed. How much decrease in economic activity is worth the greater equality? Greater knowledge of economic analysis lets people weigh these opportunity costs more carefully and thoughtfully.

3.

Does the concept of decreasing marginal benefits actually imply that rich people will lose fewer benefits from an income transfer than the poor will gain? Emphasize to the students that many social policies (both private and public) that favor the poor at the expense of the rich are justified on utilitarian grounds. Marginal income tax rates that rise .

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with income provide one obvious example. A business discount for college students (who are presumed to be poorer than the general population) is another example. Yet the students should understand that the ability to make a direct comparison of benefits lost for one person against the benefits gained by another is not implied by the concept of diminishing marginal benefits. Explain to them that the assumption of decreasing marginal benefits allows us to compare the marginal benefits across different levels of consumption for the same person, but it says nothing about comparing the marginal benefits across different people at different consumption levels.

To clarify, ask them the following question: Can we truly measure and compare the happiness from a rich person’s consumption level to a poor person’s consumption level for the same good? Have the students assume that the quantity of income taken away from a rich mother means that she is now able to send only one, rather than both, of her children to college. Assume also that the same quantity of income given to a poor mother enables her to send one of her two children to college when she otherwise couldn’t have afforded to send either child to college. Ask the students, “Does this imply that the happiness, or perceived value, lost by the rich mother is somehow smaller than the happiness, or perceived value gained by the poor mother?” Ask the students if anyone can honestly claim to know that one mother’s concern about providing for her second child is smaller in magnitude than another mothers’ concern about providing for her first child. Obviously not! Explain that if this claim is false for this example, then it is false for all examples comparing benefit gains and losses across people at different levels of in income.

4.

Do “liberals” care more about fairness than “conservatives”? Some years ago, Jim Tobin told Michael Parkin about a nice test of whether a person is a liberal or a conservative. It also generates a good classroom discussion. Here’s how it goes. Give the students the following scenario and question: You are at an oasis in a large desert and you have some ice cream in an immovable refrigerator. (Assume, for the sake of the story, that ice cream is the only food available.) The people in the next oasis some miles away have no ice cream (and no other food) and are too old and infirm to travel. You have plenty of ice cream and you can transport it to the next oasis, but on the journey, some of it will melt. Now the question: How much of the ice cream would have to survive the journey for it to be worth transporting to the next oasis?

Your students will not agree (and you may not agree with your students’ conclusions).

According to Tobin, the most liberal would transport if only the smallest percentage survived the journey. The most conservative would want a large proportion to survive before undertaking the redistribution. You can point out that different people choose different points on the “big tradeoff.” Be careful not to support one view over the other as the only correct viewpoint. The focus here is on understanding the tradeoff between fairness and efficiency, not the value of one over the other.

You could spend the rest of the course talking about and discussing equity, fairness, or distributive justice as it is sometimes called. This material is not standard, and you’ll be hard-pressed to find it in any other principles text. It is included here because governments and the news media often make judgments about what is fair and what is not fair, and students need to know what criteria are included in those judgments.

5.

When is it price gouging and when are prices “just high”? It is common at events to have extremely high prices for items such as bottled water, beer, food, prices much higher than would be paid outside the venue. Consider soda at professional baseball games or bottled water at a theme park. Prices might be double or triple what they would be outside but it isn’t considered to be illegal. Have students discuss fairness in this context and in the .

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context of the aftermath of a disaster. If a bottle of water is selling for $4 in both cases, why is only one case considered gouging? What do they think the outcome should have been for the man described in the case that purchased generators and transported them to the hurricane region to profit? Was he serving himself, others, or both, as Adam Smith would argue?

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6

GOVERNMENT ACTIONS IN MARKETS

The Big Picture Where we have been: Chapter 6 uses the demand and supply concepts of Chapter 3, the elasticity concepts of Chapter 4, and the efficiency concepts of Chapter 5 to study price ceilings and floors, taxes and subsidies, production quotas, and the markets for illegal goods. The chapter helps round out the student’s exploration of the demand and supply model and its application, and should be a fulfilling exercise for putting together the “big picture.”

Where we are going: Chapter 7 continues the theme of this chapter by exploring international trade and the effects on consumer surplus, producer surplus, and national welfare. It also examines the deadweight loss of government policies that limit trade, such as tariffs and import quotas.

Efficiency and deadweight loss are again explored as we consider how perfectly competitive markets allocate resources in Chapter 12, and then contrast that with results for monopoly (Chapter 13), monopolistic competition (Chapter 14), and oligopoly (Chapter 15). We will return to taxes and efficiency issues when we study externalities in Chapter 16 and public goods and common resources in Chapter 17.

New in the Thirteenth Edition The opener to the chapter has updated data about minimum wages and rents in New York City, which then leads to a new end of chapter article that focuses on the State of Illinois’ effort to raise the minimum wage to $15.

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CHAPTER 6

Lecture Notes

Government Actions in Markets • •

I.

Government intervention in markets—using price controls, taxes, production quotas, and making products illegal—can affect the price and quantity in those markets.

Government intervention affects the efficiency of markets and can lead to the creation of deadweight losses.

A Housing Market with a Rent Ceiling • • •

A price ceiling is a government regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to a housing market it is called a rent ceiling.

A rent ceiling set above the equilibrium rent has no effect on the market.

A rent ceiling set below the equilibrium rent creates a housing shortage, increased search activity, and a black market.

A Housing Shortage •

•

If the government imposes a rent ceiling below the equilibrium rent, then a shortage results. In the figure the equilibrium rent is $400 per month and the equilibrium quantity of units rented is 3,000. If the government imposes a rent ceiling of $200 per month, a shortage results. The quantity demanded at that price is 5,000 and the quantity supplied is 1,000. There is a shortage of 4,000 apartments per month.

Rent ceilings lead to inefficiency. In a competitive market, the equilibrium quantity is the same as the efficient quantity. In a housing market with a rent ceiling, the quantity of units available is less than the equilibrium quantity and so is less than the efficient quantity. The market underproduces, and there is a deadweight loss, as shown in the figure as the darkened triangular area.

How is the “shortage” calculated? In looking at the effects of a price ceiling, students sometimes focus only on the change in the quantity supplied relative to equilibrium instead of looking at the entire difference between the quantity demanded and quantity supplied. The shortage is measured by the difference between the quantity demanded and the quantity supplied, NOT simply by the difference between the original equilibrium quantity and the new quantity supplied.

Housing Markets and Rent Ceilings: Time and the elasticity of supply. Even given the caveat above, it is worth noting the reduction in quantity supplied of rent controlled housing, especially since policy makers’ intent is usually to make housing more available to lower income tenants and less housing is available after the policy. Where might those units and firms go instead? Recall supply elasticity from Chapter 4 and ask students how the passage of time might allow property owners to fully respond to the policy. In the long run, apartment owners are more likely to change the number of apartments they offer in response to a price ceiling than in the short run. Will they switch to condominiums? Will they be able to maintain public parts of the building given lower rents? What will happen to the average age of buildings over time .

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in a rent controlled city? Eventually, however, apartment owners may find that alternative uses for their property (as a strip mall or a storage facility, for example) become more profitable.

Increased Search Activity •

Search activity is the time spent looking for someone with whom to do business. Search activity is costly and increases the opportunity cost of a given product or service. A rent ceiling (or a price ceiling) that creates a shortage increases search activity.

A Black Market • •

A black market is an illegal market in which the price exceeds the legally-imposed price ceiling. In a black market, illegal arrangements are made between renters and landlords—often at effective rental rates that are higher than would be the case in an unregulated market.

The level of black market rent depends on how tightly the rent ceiling is enforced. When the rent ceiling is strictly enforced, black market rent will be closer to the maximum that consumers are willing to pay, which in the figure is $600 per month.

Are Rent Ceilings Fair?

• •

Using the “fair rules” criteria, blocking voluntary exchange is unfair.

Using the “fair outcomes” criteria, rent ceilings are fair if they help the poor and disadvantaged.

Some other allocative mechanism, such as a lottery, queuing, some form of discrimination is often used to allocate housing. These alternative allocation methods of distribution do not favor the poor and disadvantaged.

What is the goal of a rent ceiling? Point out to the students that replacing the market price as an allocative mechanism for the rental market conflicts with the stated goals of those who promote rent ceilings as a means to create affordable housing. Rent ceilings lead to a shortage, which means landlords have more ability to discriminate against renters who have a different color of skin, or practice a different religion, or who have “too many” tattoos or “too many” children. It can increase incentives for corruption as outright bribes or excessive deposits and charges for building services make up for below market rent.

In addition, there is less incentive for landlords to make needed electrical or plumbing repairs, or perform maintenance on appliances. Builders have less incentive to build new housing units so that in the long run, the stock of available housing will not grow with the population, making the shortage worse.

Rent Ceilings in Practice Cities with rent ceilings tend to have significant housing shortages. Some tenants, especially those who have lived longest in the city, have lower rents but others must pay higher rents.

Economics in Action: Rent Control Winners: The Rich and Famous This Economics in Action application examines the impact of rent controls in the New York City housing market.

II. A Labor Market With a Minimum Wage •

A price floor is a government-imposed regulation that makes it illegal to charge a price lower than a specified level. When a price floor is applied to labor markets, it is called a minimum wage. A minimum wage that is set above the equilibrium wage rate creates unemployment.

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Minimum Wage Brings Unemployment •

•

If a minimum wage is set above the equilibrium wage rate, the quantity of labor demanded is less than the quantity of labor supplied. This surplus of labor is unemployed workers. The minimum wage creates unemployment because some workers who are willing to work at the minimum wage will not find a job.

In the figure, the equilibrium wage is $8 an hour and the equilibrium quantity of employment is 30,000 hours per month. If a minimum wage rate of $12 is imposed, the initial equilibrium wage rate is made illegal. At the minimum age the quantity of labor supplied is 50,000 hours per month and the quantity demanded is 10,000 so there is a surplus of 40,000 hours.

The 40,000 hour surplus means that 40,000 hours of labor is unemployed.

Labor is work that households supply and firms demand. You might be surprised to find that quite a few students think that the demand for labor is the demand by a household for a job and the supply of labor is the supply of jobs by firms. Of course, they get into a big mess with this mirror image view of the labor market. Try to avoid this all-too-common mistake by being very explicit that households supply labor and firms demand it. Sure, firms provide jobs and people want jobs to earn an income. But it is labor, not jobs, that is supplied and demanded in the labor market.

Inefficiency of a Minimum Wage • •

Fewer workers are employed with a minimum wage, so less than the efficient quantity of workers is employed. At the quantity of labor employed, the marginal social benefit of labor exceeds its marginal social cost.

Because the quantity of labor employed is less than the efficiency quantity, there is deadweight loss. In addition to the deadweight loss, there is also increased job search. Higher job search costs borne by workers add to the loss from the minimum wage.

The Minimum Wage in Practice •

While some estimates say that a 10 percent rise in the minimum wage results in a decrease in employment 1 to 3 percent (particularly among teenagers), other economists argue that higher minimum wages have little impact—and potentially even a positive impact—on employment. Such studies emphasize the idea that higher wages reduce a given employee’s incentive to quit, thereby reducing recruitment and training costs for employers and increasing labor productivity and labor demand.

Is the Minimum Wage Fair?

•

The minimum wage is unfair based on an evaluation of both the “result” and the “rules” of a minimum wage. The result if unfair because workers who become unemployed are worse off than they would be with no minimum wage. The minimum wage imposes an unfair rule because it blocks voluntary exchange. Even if firms are willing to hire more labor at a wage that people are willing to take, they are not permitted to do so by the minimum wage law.

At Issue: Does the Minimum Wage Cause Unemployment?

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This At Issue examines the issue of whether the minimum wage creates unemployment. In addition to considering the Yes and No cases presented for the minimum wage, consider pulling up data on unemployment rates by educational level and race. Minority teens in urban areas have significantly higher rates than other populations. Ask your students why they think this situation exists? Perhaps the minimum wage has become a price floor about equilibrium for this population as they have to compete with more experienced, older workers. You can also ask them if they think this outcome is “fair”? Given that many students are often paid the minimum wage, asking them if they think the differential outcome is fair can create an interesting and perhaps even heated discussion.

III. Taxes Tax Incidence •

Tax Incidence is the division of the burden of a tax between the buyer and the seller. The buyers’ burden arises when the price paid by the buyers rises after the tax is imposed. The sellers’ burden arises when the price they receive falls after the tax is imposed. Tax incidence does not depend on whether the tax law imposes the tax on buyers or on sellers.

A Tax on Sellers •

•

Imposing a tax on sellers decreases supply because the tax is like a cost that sellers must pay. The supply curve shifts leftward. The vertical distance between the initial supply curve and the new supply curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases.

The figure shows the effect of a tax imposed on sellers. The initial price is $12 per CD and the initial quantity is 10 thousand CDs per week. When the tax is imposed, the supply curve shifts from S to S + tax. The length of the double headed arrow showing the vertical distance between the two supply curves equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per CD, sellers receive $11 per CD, and the quantity of CDs purchased decreases to 9 thousand CDs per week.

A Tax on Buyers •

•

Imposing a tax on buyers decreases demand because the tax lowers the amount they are willing to pay to the sellers. The demand curve shifts leftward. The vertical distance between the initial demand curve and the new demand curve is equal to the amount of the tax. The price paid by buyers rises, the price received by sellers falls, and the quantity decreases.

The figure shows the effect of a tax imposed on buyers. The initial price is $12 per CD and the initial quantity is 10 thousand CDs per week.

When the tax is imposed, the demand curve shifts from D to D − tax. The length of the .

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double headed equals the amount of the tax, $2. With the tax imposed, buyers pay $13 per CD, sellers receive $11 per CD, and the quantity of CDs purchased decreases to 9 thousand CDs per year.

Equivalence of Tax on Buyers and Sellers •

The figures above confirm the general conclusion: Regardless of whether the tax is imposed on buyers or sellers, the tax leads to the same outcome in which the new equilibrium price and quantity are identical. The tax burden is split the same way regardless of who is responsible for paying the tax to the government.

Tax Incidence and Elasticity of Demand • •

With perfectly inelastic demand (a vertical demand curve), the buyer pays the entire tax. In general, the less elastic the demand, the larger the tax burden paid by the buyers (and the smaller the tax burden paid by the sellers).

With perfectly elastic demand (a horizontal demand curve) the seller pays the entire tax. In general, the more elastic the demand, the smaller the tax burden paid by the buyers (and the larger the tax burden paid by the sellers).

Tax Incidence and Elasticity of Supply • •

With perfectly inelastic supply (a vertical supply curve) the seller pays the entire tax. In general, the less elastic the supply, the larger the tax burden paid by the sellers (and the smaller the tax burden paid by the buyers).

With perfectly elastic supply (a horizontal supply curve) the buyer pays the entire tax. In general, the more elastic the supply, the smaller the tax burden paid by the sellers (and the larger the tax burden paid by the buyers).

Do consumer prices always rise when taxes rise? As long as the demand curve is not horizontal and the supply curve is not vertical, when a tax is hiked buyers will bear some of the burden of a tax and the prices they pay for good will increase. The elasticity of demand relative to the elasticity of supply is the key to determining how much burden each side of the market will bear. Consider the situation faced by smokers when the tax on cigarettes is increased. First, the demand for cigarettes is relatively inelastic. (Ask your students why they would expect cigarettes to have a relatively low elasticity of demand, relying on the determinants of elasticity presented in Chapter 4.) With relatively inelastic demand, when the government raises taxes on cigarettes, the price paid by buyers rises substantially. The incidence of the tax falls heavily on buyers. In addition, state governments have sued tobacco companies for past and future health care costs arising from the smoking-related illnesses. Tobacco companies settled these suits, paying billions of dollars in penalties, which raised their costs and decreased their supply. But smokers’ very inelastic demand for cigarettes means that the tobacco producers were able to pass on most of these costs to smokers without seeing a significant decrease in the quantity sold. On the other hand, when taxes were imposed on luxury yachts in the 1990s, because the demand for yachts was relatively elastic, yacht buyers drastically reduced their yacht purchases, and shipbuilders bore most of the burden of that tax.

Taxes and Efficiency •

Taxes drive a wedge between the price buyers pay and sellers receive. Therefore, they put a wedge between marginal benefit and marginal cost and create inefficiency. The quantity produced is less than the efficient quantity.

Economics in Action: Workers and Consumers Pay the Most Tax This Economics in Action case considers the incidence of employment and excise taxes and concludes workers and consumers are most responsible for paying them.

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Taxes and Fairness The Benefits Principle •

The benefits principle is the proposition that people should pay taxes equal to the benefits they receive from the services provided by government.

The Ability-to-Pay Principle •

The ability-to-pay principle is the proposition that people should pay taxes according to how easily they can bear the burden on the tax.

Examples: The federal excise tax on gasoline is an example of the “benefits principle” of taxation. Revenue collected from excise taxes on gasoline are used to finance interstate maintenance and improvements. To the extent that the purchasers of gasoline are the same people who use the interstates, then gas taxes are paid by those who receive the benefits of public interstates. On the other hand, income taxes are an example of the “ability-to-pay” principle. The progressive marginal tax rates of the U.S. tax code require those with higher incomes to pay a greater share of government expenditures.

IV. Production Quotas and Subsidies Production Quotas • •

A production quota is an upper limit to the quantity of a good that may be produced in a specific period of time. Production quotas will only have an impact if they are set below the equilibrium level of output in a market.

A production quota results in a decrease in supply, a rise in price, a decrease in marginal cost, inefficiency from underproduction, and an incentive to cheat and overproduce.

Subsidies • •

A subsidy is a payment made by the government to a producer. A subsidy increases the supply.

A subsidy results in an increase in supply, a fall in price and increase in quantity produced, an increase in marginal cost, payment to producers by the government, and inefficiency from overproduction.

Economics in Action: Rich High-Cost Farmers the Winners This Economics in Action examines farm subsidies and the tension they are creating between developed and developing countries.

V. Markets for Illegal Goods The government prohibits the trade of some goods, such as illegal drugs. Yet markets still exist, with both buyers and sellers engaging in trade.

A Free Market for a Drug •

With no penalties for selling or buying drugs, drug prices would be lower and more would be sold.

A Market for an Illegal Drug • • •

Imposing penalties on sellers decreases the supply and shifts the supply curve leftward compared to the free market case. These penalties raise the price and decrease the quantity.

Imposing penalties on buyers decreases the demand and shifts the demand curve leftward compared to the free market case. These penalties lower the price and decrease the quantity.

When both buyers and sellers face penalties, both the demand and supply curves shift leftward.

The quantity decreases but the effect on the price is ambiguous.

• If the decrease in demand exceeds the decrease in supply, the price falls.

• If the decrease in demand equals the decrease in supply, the price does not change.

• If the decrease in demand is less than the decrease in supply, the price rises. .

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Legalizing and Taxing Drugs •

•

Compared to a legal and untaxed market, if drugs are legal and taxed, the price of drugs will be higher and the quantity consumed will be lower. But a high tax rate might be necessary to decrease the consumption of drugs to the level that occurs when they are illegal and so black markets might arise.

An advantage of legalization and taxation is that the government can raise tax revenues for educating the population against using drugs. A disadvantage is that legalization might signal that drugs are socially acceptable, which could increase demand.

Economics in the News: Push to Raise the Minimum Wage State Minimum Wages Rising to Exceed the Federal Minimum This Economics in the News examines the push to raise state minimum wages above the federal minimum wage. This is a very timely issue for students to apply their recently learned economic analysis skills to understand. It shows how a minimum wage set above the equilibrium wage rate creates unemployment while a minimum wage set below the equilibrium wage rate has no effect.

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Additional Problems 1.

Figure 6.1 shows the demand for and supply of rental housing in Township. a. What are the equilibrium rent and equilibrium quantity of rental housing?

If a rent ceiling is set at $150 a month, what is b. The quantity of housing rented? c. The shortage of housing? d. The maximum price that someone is willing to pay for the last unit available?

2.

The table gives the demand schedule Wage rate Quantity Quantity and the supply schedule for high (dollars per demanded supplied school graduates. hour) (hours per month) a. What is the equilibrium wage and the 6 9,000 4,000 equilibrium quantity of employment.

7 8,000 5,000 b. What is the number of hours of labor 8 7,000 6,000 unemployed?

9 6,000 7,000 c. If a minimum wage is set at $7 an 10 5,000 8,000 hour, how many hours do high school graduates work? d. If a minimum wage is set at $7 an hour, how many hours of labor are unemployed? e. If a minimum wage is set at $9 an hour, what are the number of hours of labor employed and the number of hours of labor unemployed? f. If the minimum wage is $9 an hour and demand increases by 500 hours a month, what is the wage rate paid to high school graduates and how many hours of their labor are unemployed?

3.

The demand and supply schedules for coffee are given in the table. a. If there is no tax on coffee, what is the price of a cup of coffee and how much coffee is bought? b. If a tax of 75¢ a cup is introduced, what is the price of a cup of coffee and how much coffee is bought? Who pays the tax?

.

Price (dollars per cup) 1.50 1.75 2.00 2.25 2.50

Quantity Quantity demanded supplied (cups per hour) 90 30 70 40 50 50 30 60 10 70

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Solutions to Additional Problems 1.

a. b. c.

d.

2.

a. b. c.

d. e.

f.

3.

a. b.

Equilibrium rent is $300 a month and the equilibrium quantity is 30,000 housing units.

The quantity rented is 10,000 housing units. The quantity of housing rented is equal to the quantity supplied at the rent ceiling.

The shortage of housing is 40,000 housing units. At the rent ceiling, the quantity of housing demanded is 50,000, but the quantity supplied is 10,000, so there is a shortage of 40,000 housing units.

The maximum price that someone is willing to pay for the 10,000th unit available is $450 a month.

The demand curve tells us the maximum price that someone is willing to pay for the 10,000th unit.

The equilibrium wage rate is $8.50 an hour, and employment is 6,500 hours a month.

Unemployment is zero. Everyone who wants to work for $8.50 an hour is employed.

They work 6,500 hours a month. A minimum wage rate is the lowest wage rate that a person can be paid for an hour of work. Because the equilibrium wage exceeds the minimum wage, the minimum wage is ineffective. The wage rate will be $8.50 an hour and employment is 6,500 hours.

There is no unemployment. The wage rate rises to the equilibrium wage—the quantity of labor demanded equals the quantity of labor supplied. So there is no unemployment.

At $9 an hour, 6,000 hours a month are employed and 1,000 hours a month are unemployed. The quantity of labor employed equals the quantity demanded at $9 an hour. Unemployment is equal to the quantity of labor supplied at $9 an hour minus the quantity of labor demanded at $9 an hour.

The quantity supplied is 7,000 hours a month, and the quantity demanded is 6,000 hours a month.

So 1,000 hours a month are unemployed.

The wage rate is $9 an hour, and unemployment is 500 hours a month. At the minimum wage of $9 an hour, the quantity demanded is 6,500 hours a month and the quantity supplied is 7,000 hours a month. So 500 hours a month are unemployed.

With no tax on coffee, the price is $2.00 a cup and 50 cups an hour are bought.

The price is $2.25 a cup, and 30 cups an hour are bought. Consumers pay 25 cents of the tax on a cup of coffee and sellers pay 50 cents of the tax on a cup of coffee. The tax decreases the supply of coffee and raises the price of coffee. With no tax, sellers are willing to sell 30 cups an hour at $1.50 a cup. But with a 75 cent tax, they are willing to sell 30 cups an hour only if the price is 75 cents higher at $2.25 a cup.

Additional Discussion Questions 1. Do rent controls improve the quality of life for university students? The following provides a useful example to make the issue of market price regulation personally relevant for the students. Inform them that the University of California is located in the city of Berkeley, California, where the city government imposes strict rent controls. The University of Florida is located in Gainesville, Florida, where there are no rent controls.

In which city would you expect incoming freshman students to have the least trouble renting an apartment? The students should understand that while apartments with low monthly rents would be very nice, they would also be very scarce due to a market shortage.

Emphasize that under a rent control policy, not only are there fewer apartments for lease than if the market were unregulated, there are also many more students looking for an apartment who wouldn’t have even thought about renting at the higher rental rates of the unregulated market.

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Who ultimately gets the apartments? Students should see that the available units must be allocated somehow. Too many students trying to locate too few apartments means a new student will face the following difficulties: • Significant increase in search costs, such as time spent, gasoline consumed, and promising leads followed for nothing, etc.

• Greater risk of being rejected by landlords simply for being the “wrong” race or ethnic background; having the “wrong” religious beliefs or personal attributes.

• Unscrupulous landlords requiring huge deposits; charging premiums for electricity or natural gas consumed; gouging the renters for minor maintenance actions; delaying important repairs to air conditioning or heating units or leaking plumbing fixtures.

If rent control laws fail to promote fairness, what about efficiency? Students should see that having a rent control policy means the economy suffers from three sources of inefficiency (meaning net benefits to society are not maximized): • Those who get an apartment are not always the ones who value it the most.

• Difference in the marginal benefit and marginal cost at the level of housing produced means that too few resources are used for producing the rental housing market, creating a deadweight loss.

• Underused resources in the rental housing market imply that too many resources are used in other markets, resulting in the overproduction of goods and services in those markets.

2.

3.

After the OPEC oil embargo in the 1970s, price controls were placed on gas markets that did not allow price to rise to the market clearing level. Gas shortages resulted as did black markets. Use the analysis provided in Chapter 6 on the use of price controls to discuss whether price controls likely hurt or helped consumers and the economy.

Consider the following: • Who is helped and harmed by price ceilings?

• Had gas prices been allowed to increase sharply, would we have made changes in our economy faster? At what cost?

• How does the elasticity of demand and supply impact the degree to which price and quantity would change in the gasoline market?

Price controls on gas meant people had to deal with gas shortages, informal rationing, and black markets, which reduced their ability to purchase gasoline even if the price of gasoline did not rise enough to reflect the change in market conditions. Firms paying higher costs and unable to charge higher prices would leave the market, willingly or through economic losses. Higher prices create incentives for people to reduce their purchases and find substitutes. Higher prices increase incentives for firms to develop alternate sources.

Will raising the minimum wage help or hurt those who need help the most? This question makes students apply simple demand and supply analysis to discover the counterintuitive implications from market regulation policies. Point out that minimum wage laws have at least two devastating impacts on the very people that supporters of a minimum wage say need these jobs the very most: • The higher wage attracts people with higher qualifications—like college students—to seek unskilled labor jobs that they wouldn’t otherwise seek out at a lower, unregulated wage. This means unskilled laborers who are heads of households are competing to get jobs against greater numbers of relatively more educated college students with relatively greater human capital. .

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•

Additionally, when employers determine which workers they are going to lay off after a raise in minimum wage takes effect, they are first going to release those employees with the least skills and the least experience. Those are precisely the characteristics of many uneducated, minority workers who are in the greatest need of retaining any paying job to ensure a better future.

Students should understand that both of these results are the unintended consequences of trying to manipulate the market forces of supply and demand.

4.

What specifically are the “inefficiencies” of agriculture policies that prop up farm prices? Get the students to integrate concepts from many different chapters with the following example of agricultural market regulation. Inform students that the federal government regulates agriculture markets in many ways: i) it pays farmers to NOT produce output to prop up farm prices; ii) it uses output quotas to limit total farm production; and iii) it imposes price floors and pays farmers for any unsold, surplus quantities. Have the students examine the impact of such market regulation and recognize that: • Too many resources are used in the agriculture markets, causing a deadweight loss from overproduction. Too few resources are used in other competitive, unregulated markets, causing deadweight loss from underproduction. Remind the students that even if the deadweight losses were not realized, society would still be moving to a lower valued point on the production possibilities frontier.

• The federal government uses additional resources managing the huge surplus agricultural inventories, some of which (milk, e.g.) is very perishable and requires expensive storage facilities. Much of these perishable farm goods are spoiled before it is decided what could be done with them without depressing the market price. This implies that society is moving towards the interior of the production possibilities frontier. (If an agricultural product cannot be stored, it can sometimes be converted to other goods, like cheese. Alternatively, surplus product can be “dumped” on the world market, thereby depressing the equilibrium price of the product on the world market— to the detriment of small agrarian countries.)

• The higher prices for food are used to justify increases in food stamp allotments to the poor and disadvantaged, increasing the tax revenues necessary to pay for this program.

Higher tax burdens increase the deadweight loss to all markets that are taxed. This implies that society is moving even further to the interior of the production possibilities frontier.

5.

What are “sin taxes”? Ask your students to think about some of the markets mentioned in the chapter that are heavily taxed (cigarettes, for example). Alcohol purchases are also subject to federal excise taxes. Some of these taxes are often referred to as “sin” taxes. Ask students why they think that is the case. Consumption of cigarettes and alcohol is traditionally considered somewhat “taboo” (or at least unhealthy), so purchases of these products are subject to a sin tax. By taxing this consumption, the quantity consumed of these goods will decrease (although not by much if the demand for these goods is relatively inelastic).

• Ask your students whether they think a tax on gasoline is a sin tax. While it may not be “sinful” or unhealthy personally to buy gasoline, some politicians actually favor increasing taxes on gasoline to further discourage use of this scarce fossil fuel. They argue that use of gasoline is unhealthy for the environment. As with other sin taxes, part of the motivation for the tax on gasoline is the resulting reduction in consumption.

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6.

7.

8.

9.

73

How are taxes related to tax revenues? In markets with relatively inelastic demand, consumers bear most of the burden of taxes, and the quantity purchased of those goods decreases only slightly in response to higher prices. As a result, markets with relatively inelastic demand would also be expected to generate high tax revenues. On the other hand, imposing taxes in markets where demand is relatively elastic would result in large reductions in consumer purchases and, ultimately, smaller collections of tax revenue.

Show this result to your students graphically, reminding them that “less elastic” demand would be steeper and “more elastic” demand would be flatter. The area of tax revenue has a smaller base when the quantity consumers purchase falls dramatically when prices rise (i.e., when a tax is imposed in a market where demand is relatively elastic). The area of tax revenue has a larger base when the quantity consumers purchase falls only a little when prices rise after the tax (i.e., when a tax is imposed in a market where demand is relatively inelastic).

Example: Use Figure 6.5 in the text. With a tax of $1.50 imposed in the market, the price of cigarettes rises to $4, and the quantity purchased falls from 350 million to 325 million.

The government therefore collects ($1.50 x 325 million = $487.5 million) in revenue. What if the quantity of cigarettes purchased had fallen only to 335 million instead of 325 million?

In other words, what if the demand for cigarettes was less elastic? Now the government would collect (1.50 x 335 million = $502.5 million) in revenue. (Note that the “sin” taxes placed in markets with relatively inelastic demand are likely to be the very markets that generate the greatest government tax revenue as well.)

How are elasticity and deadweight loss related? Show your students how the size of the deadweight loss triangle is related to elasticities as well. With linear supply and demand curves, the area of deadweight loss is a triangle with a height equal to the amount of the tax (the vertical distance between the two supply or demand curves) and a base equal to the decrease in the quantity purchased as a result of the tax. For any given tax, the only difference in deadweight loss across two markets will be the size of the decrease in the quantity purchased as a result of the tax. You can show this graphically by showing deadweight loss when demand is relatively steep as opposed to deadweight loss when demand is relatively flat. Just make sure you use the same tax (same vertical distance between the two supply curves) in the comparison.

A Swedish economist famously noted that rent controls are possibly the best way to destroy a city, except perhaps for bombing it. Explain why this might be true. If rents are below market, it is hard for firms to cover their production costs. As time passes, building maintenance suffers, roofs aren’t replaced, new construction is eliminated, and the housing stock deteriorates.

USA Today recently reported that significant increases in federal cigarette taxes (more than $1 per pack) led to a significant increase in the number of people who quit smoking, especially among teens, seniors, and low income individuals. Discuss what this means about elasticity, potential government revenue from the cigarette tax, and the goals government is trying to accomplish through “sin” tax policy. Do governments really want people to quit? If enough people quit so that the tax revenue falls, demand has hit the elastic portion of the curve. If government truly wants people to quit, taxes must be high enough to reach that portion of the curve. If government, however, wants tax revenue to help meet budget goals, they do not want to set the tax so that it moves demand into the elastic part of the demand. What do the students think is the “true” goal of the government?

You can return to this discussion after discussing externalities when it will be even more meaningful. .

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C h a p t e r

7

GLOBAL MARKETS IN ACTION

The Big Picture Where we have been: Chapter 2 introduced the gains from trade in a simple model with a linear production possibilities frontier. This chapter continues the explanation of the gains from trade by looking at individual markets using demand and supply. The chapter uses the concepts of consumer surplus, producer surplus, and deadweight loss, first introduced in Chapter 5.

Because of this mode of analysis, the chapter now integrates tightly with the preceding chapter, which examined changes in consumer surplus, producer surplus, and deadweight loss resulting from government policies. The chapter examines trade restrictions and protection with a focus on the deadweight loss resulting from trade restrictions.

Where we are going: Chapter 7 marks the end of the basic applications of supply and demand analysis. Chapters 8 and 9 cover utility theory and indifference curves in explaining consumer demand, and Chapters 10 to 15 develop the theory of the firm and supply decisions.

New in the Thirteenth Edition The Economics in Action application has been updated to incorporate new data about the U.S. trade pattern with the rest of the world. Both the in-chapter and end of chapter Economics in the News articles have been changed. The new in-chapter example addresses the U.S.-Canada lumber dispute. The chapter closes considering the costs of a tariff on Mexican products to pay for the proposed border wall.

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Lecture Notes

Global Markets in Action • • •

Comparative advantage means that all countries can gain from trade.

Total surplus increases with international trade.

There are many arguments in favor of restricting international trade, but restricting free trade results in deadweight loss and inefficiency.

The first Economics in Action application shows the major U.S. exports and imports. A great source of information about global business for undergraduates is Global Edge, which is hosted by Michigan State University (http://globaledge.msu.edu). This site compiles information from many sources and is great entry point for student research, in addition to hosting modules and other resources for global business.

Students can search by state or country to compare what is traded and to get an overview of the economies of other regions.

I.

How Global Markets Work • • • •

The goods and services that we buy from people in other countries are called imports. The goods and services that we sell to people in other countries are called exports.

The United States is the world’s largest international trader and accounts for 10 percent of world exports and 13 percent of world imports.

In 2013, U.S. exports were $2.3 trillion (about 14 percent of the value of U.S. production) and U.S. imports were $2.7 trillion (about 17 percent of total U.S. expenditure).

The fundamental force that generates international trade is comparative advantage. A country has a comparative advantage in producing a good if it can produce that good at a lower opportunity cost than any other country. By specializing in producing the good in which each country has comparative advantage, both countries gain from international trade.

For more data on international trade: The data on U.S. international trade can be accessed at the Bureau of Economic Analysis web site: www.bea.gov/international/index.htm. Key facts worth emphasizing are the enormous growth in volume of trade over time and huge two-way trade in manufactures. Explain that the balance of trade along with the international borrowing and lending that finances it results from spending and saving decisions in the United States and the rest of the world, and is independent of the forces that generate the volume of trade, which this chapter covers.

U.S. Exports •

•

The United States will export goods for which it has comparative advantage. In the figure the world price of coal is $60 per ton and the price in the United States before trade is $40 per ton.

The United States has a comparative advantage in producing coal because the price before trade is lower than the world price. In this case the United States will export coal.

In the figure, before international trade the price of coal in the United States was $40 per ton and at that price the United States produced 3 million tons of coal per year and consumed 3 million tons per year. With international trade, the price in the United States rises to the world price, $60 per ton. At that price the United States produces 5 million tons of coal per year, .

GLOBAL MARKETS IN ACTION

consumes 1 million tons per year, and exports the difference, 4 million tons per year.

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U.S. Imports •

•

The United States will import goods in which it does NOT have a comparative advantage. In the figure, the world price of automobiles is $20,000 per car and the price in the United States before trade is $40,000 per car, so the United States does not have a comparative advantage in producing automobiles. In this case the United States will import cars.

In the figure, before international trade the price of a car in the United States was $40,000 per car and at that price the United States produced 3 million cars per year and consumed 3 million cars per year. With international trade the price in the United States falls to the world price, $20,000 per car. At that price the United States produces 1 million cars per year, consumes 5 million cars per year, and imports the difference, 4 million cars per year.

II. Winners, Losers, and the Net Gain from Trade U.S. Exports •

Exports raise the U.S. price of the good or service. With the higher price consumers lose and producers gain. The figure shows this breakdown of winners and losers. Consumer surplus decreases from area A + area B to only area A. Producer surplus increases from area D to area B + area C + area D. The increase in producer surplus more than offsets the decrease in consumer surplus, so total surplus increases.

The total surplus increases by area C. Also note that the loss to consumers, area B, is picked up as a gain to producers.

U.S. Imports •

Imports lower the U.S. price of the good or service. With the lower price consumers win and producers lose. The figure shows this breakdown of winners and losers. Consumer surplus increases from area A to area A plus area B + area C. Producer surplus decreases from area B + area D to only area D. The increase in consumer surplus more than offsets the decrease in producer surplus, so total surplus increases. The total surplus increases by area C. Also note that the loss to producers, area B, is picked up as a gain to consumers.

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The Fable of Adam Blackbox: There is an enormously rich heritage of stories, parables, fables, and satires that you can use to enliven your classes on this topic. The following fable, inspired by James Ingram (from International Economic Problems, John Wiley, 1970) is a powerful way to begin. Make up your own version with local flavor and embellishment.

Adam Blackbox announces that he has discovered an amazing way to produce low-price, high-quality automobiles. He sets up a plant on a large tract of land along the coast of Massachusetts, hires 10,000 employees, swears them to secrecy, and begins delivering his low-price, high-quality autos to the nation’s showrooms. Adam Blackbox is hailed as an American industrial hero. Blackbox Enterprises floats stock and Wall Street booms. Consumers love him. His automobiles are better and cheaper than those they could buy before he came along. Automakers hate him, but their attempts to pass laws to restrict his operations fail. The president and Congressional leaders explain that economic adjustment is an inevitable consequence of technological advance. And Adam Blackbox’s new technology for delivering low-price, high-quality automobiles is clearly part of the process of achieving greater prosperity for all.

The press becomes increasingly curious about what is going on in the giant New England auto plant.

Investigative journalists create endless hours of speculative television programming on the amazing new technology. Then a tabloid journalist with a big checkbook finds a worker who is willing to talk. Adam Blackbox's secret is revealed. Nothing is produced at the plant. Adam Blackbox is a trader, not a producer.

He buys grain from American farmers, exports it to Japan, and imports automobiles from Japan. His secret revealed, Adam Blackbox is hauled before Congressional committees on fair trade and denounced as an evil destroyer of American jobs. The president makes a special State of the Union speech in which he denounces Adam Blackbox, praises a vigilant press for saving Americans from the threat of cheap foreign labor, and announces a new budget initiative that will spend $50 billion on research in technologies to produce low cost, high-quality automobiles.

Ask your students why the president and Congress accepted Adam Blackbox initially but then changed their tune. Was Adam Blackbox hurting America or helping America?

III. International Trade Restrictions •

Governments restrict international trade to protect domestic industries from foreign competition using tariffs, import quotas, other import barriers, and subsidies

Tariffs • •

•

A tariff is a tax that is imposed by the importing country when an imported good crosses its international boundary.

A tariff increases the price in the nation for the good. If the supply to the nation from the rest of the world is perfectly elastic, the price rises by the full amount of the tariff. The following occur: • Consumers buy less of the good and producers increase the quantity supplied • Government collects tariff revenue equal to the tariff times the quantity imported of the good • Less of the good is imported • A deadweight loss results.

As a result of a tariff, U.S. consumers of the good lose more than U.S. producers gain, creating a deadweight loss. All these results are shown in the figure. The government imposes a $10,000 per car tariff on imported automobiles so the U.S. price rises to $30,000. U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per .

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year to 2 million. Imports decrease from 4 million per year to 2 million. Consumer surplus decreases from area A + area B + area C + area D + area C to only area A. Producer surplus grows from area E to area E + area B. The government gains tariff revenue equal to area D. But both areas C are now deadweight losses, so on net society is harmed by the tariff.

Two notes on the impact of tariffs to point out to students: First, when a tariff is imposed imports decrease more than domestic production increases. Flipping this observation around means that when tariffs are lowered, imports increase by more than domestic production decreases. Basically, every unit we import is not a lost sale to a domestic firm. Indeed, if domestic supply is inelastic and demand elastic, domestic production may expand very little even with a huge drop in imports. Second tariffs basically force foreign firms to be more efficient than domestic firms, something that harms incentives and may limit domestic firms’ opportunities in the long run. They also can give foreign firms the incentive to move operations into the domestic economy. For instance Japanese automakers opened many manufacturing plants in the United States when their imports to the U.S. economy were limited. The upshot? U.S. automakers now face competition from Toyota, Honda, and many other automakers that have set up shop in the United States.

The Economics in Action application in this section considers the decrease in U.S. tariffs over time. This feature gives you a good chance to discuss the current state of global trade negotiations.

Import Quotas • •

•

An import quota is a restriction that limits the maximum quantity of a good that may be imported in a given period.

An import quota increases the price in the nation for the good. As a result, the following occur: • Consumers buy less of the good and producers increase the quantity supplied • The importers gain additional profit • Less of the good is imported • A deadweight loss results.

As was the case with a tariff, with an import quota U.S. consumers of the good lose more than U.S. producers gain, creating a deadweight loss.

All these results are shown in the figure. The government imposes a 2 million per year import quota on automobiles as shown. With this quota, the supply curve becomes the U.S. supply curve below the world price of $20,000 per car and then the U.S. supply curve plus the 2 million import quota at prices above the $20,000 world price. The U.S. price rises to $30,000 per car. As a result U.S. consumption of cars decreases from 5 million per year to 4 million and U.S. production increases from 1 million per year to 2 million so that imports decrease from 4 million per year to 2 million. Consumer surplus decreases from area A + area B + area C + area D + area D + area C to only area A. Producer surplus grows from area E to area E + area B. The importers’ profit is equal to the total area D. Both areas C are deadweight losses, so on net society is harmed by the import quota.

An Economics in the News case considers why the United States has switched from exporting to importing coat hangers. It examines the potential impact of a 21 percent tariff on imports of coat hangers.

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Other Import Barriers • •

Although they might not have been designed to limit international trade, health, safety, and regulation barriers have that effect.

Voluntary export restraints, while not common, act like a quota and exist if a country negotiates with foreign trade partners to voluntarily limit their exports.

An Economics in Action case discusses the Doha Development Agenda, the World Trade Organization and the problems with reaching agreement. Again, this is a good opportunity to have students research the current status of this negotiation and the industries that are most affected.

Export Subsidies •

An export subsidy is a payment by the government to the producer of an exported good. These are illegal under most international trade agreements. One of the reasons that progress on international trade agreements such as the Doha Round has been difficult is that the United States and European Union pay subsidies to their farmers, which would be illegal under the past trade agreements reached for most other goods and services.

IV. The Case Against Protection

Arguments for protection include the following: • The infant-industry argument: The so-called infant-industry argument for protection is that protection is necessary for a new industry to enable it to grow into a mature industry that can compete in world markets. The idea relates to dynamic comparative advantage—comparative advantages change over time due to learning-by-doing. However, the infant industries argument only applies if the benefits of learning-by-doing spill over to other industries and if firms have incentives to become more competitive over time, something that protection tends to limit.

• The counteracts dumping argument: Dumping occurs when a foreign firm sells its exports at a lower price than its cost of production. Dumping might be used by a firm that wants to gain a global monopoly. However, it is difficult to measure the cost of production, so whether dumping is taking place is difficult to determine. Charging a different export price than domestic price is not necessarily evidence of dumping because firms often sell goods and services for different prices in different markets.

• Saves domestic jobs: The argument that trade protection saves jobs is flawed. International trade changes the type of jobs in an economy, but it does not decrease employment in the aggregate because jobs lost in one sector are offset by jobs created in other sectors.

• Allows us to compete with cheap foreign labor: The argument that trade protection allows us to compete with cheap foreign labor is flawed. Differences in wage rates generally reflect differences in productivity, and competitiveness is determined by both differences in wages and differences in productivity.

• Penalizes lax environmental standards: The argument that trade liberalization leads to a “race-to-thebottom” in environmental standards is weak. Many poorer countries have comparable environmental standards and should not be targeted. And environmental standards are positively related to income (they are a normal good). The best way to encourage improved environmental standards is to allow trade and the economic benefits it brings to poorer countries.

• Prevents rich countries from exploiting developing countries: The argument for protection to prevent people of the rich industrial world from exploiting the poorer people of the developing countries is wrong. While wage rates in many developing countries are very low, they would be even lower without foreign demand for the goods that these countries produce. Through trade, countries gain access to capital and new technology that will speed development and the growth of living standards.

• Reduces offshore outsourcing that sends good U.S. jobs to other countries: When U.S. firms send jobs that could be done in America to another country, they are offshoring. If U.S. firms buy finished .

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goods from other U.S. or foreign firms, they are outsourcing. Offshoring brings gains from specialization, but those who have invested in human capital to do a specific job that has now gone offshore will be hurt. The actual number of jobs lost to offshoring is small but these people are hurt even though the overall economy gains.

Does offshoring help or hurt the U.S. economy? A nifty “At Issue” application discusses this issue. It presents the conventional non-economist view that offshoring is bad and contrasts that with the conventional economist view that offshoring is similar to other (beneficial!) international trade.

Does free trade exploit workers in developing countries? Students might be somewhat familiar with the terminology of “exploitation.” Have the students think about what “exploitation” means in the context of voluntary trade. If I benefit from someone I trade with, did I exploit them? Did they exploit me? If trade is voluntary, how did I manage to exploit the person whom I traded with? Is it because I am smarter than the other person? This seems to be the condescending assumption of those who talk about exploitation of workers in developing countries. Indeed, representatives from many developing countries do not see trade as exploitation, but rather see it as a way to improve standards of living. When these representatives are upset at WTO meetings, it is usually about the trade restrictions rich countries place on imports from developing countries keeping developing countries poor.

Why is International Trade Restricted?

Despite arguments against protection, trade is still restricted because key economic interests benefit from protection.

• Tariff revenues provide a relatively inexpensive way for the government to collect revenues.

• Rent seeking is lobbying and other political activity that seeks to capture the gains from trade.

While the benefits from liberalized trade are large in the aggregate, they are widespread across all consumers. Meanwhile, the costs are concentrated on a smaller number of producers. It is in the interests of those who pay the costs of liberalized trade to undertake a large quantity of political lobbying to promote protection.

• If the gains from free trade exceed the losses, it is possible to compensate the losers so that everyone can be in favor of free trade. To some extent, unemployment compensation and jobretraining programs are designed to serve this purpose. However, providing compensation is difficult because it is hard to identify exactly who has lost a job as a result of free international trade and not because of other reasons.

Another fable: There is also a rich heritage of stories, parables, fables, and satires on protectionism. But it is hard to beat Bastiat’s. Claude Frederic Bastiat (1801–1850) is a very interesting French economist. An ardent advocate of free trade, he wrote articles with Richard Cobden (the famous English free trader and opponent of the Corn Laws). His most wonderful piece is his satirical “Pétition des marchands de chandelles …” or “Petition from the Manufacturers of Candles, Tapers, Lanterns, Sticks, Street Lamps, Snuffers, and Extinguishers, and from Producers of Tallow, Oil, Resin, Alcohol, and Generally of Everything Connected with Lighting,” to give it its full title. The basic idea is that the sun creates unfair competition for candle merchants and a law must be passed to ban all windows and other openings that enable it to shine its light inside buildings. You can have a lot of fun with it not only in the context of trade, but also to talk about opportunity cost and production possibilities.

For further reading: If you haven’t already done so, read this nice little book and use its basic ideas to illustrate and illuminate the analysis of the false arguments of protectionists: Russell D. Roberts, The Choice: A Fable of Free Trade and Protectionism, 3rd Edition, 2007, Prentice Hall (ISBN: 0131433547).

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The book tells the story of David Ricardo being granted God’s permission to return to Earth and meet with Ed Johnson, a 1950s U.S. television manufacturer. Ricardo has some powers that enable him to create counterfactuals and to travel through time. The dialogue between Ricardo and Johnson provides a powerful commentary on the benefits of free trade and the costs of protectionism.

Unrestricted international trade benefits all the countries involved with trade. Emphasize the key benefits from unrestricted international trade: --The gains from international trade arise from the diversity of opportunity costs of production across countries. The source of prosperity in free trade arises from each country generating gains from specialization in their comparative advantage, minimizing its own opportunity cost of production, and sharing in each of the other country’s gains.

--Both exporting and importing domestic industries benefit from free trade. Free trade liberates each country’s consumption possibilities from the bonds of their own production possibilities frontier, enabling the consumers in both the importing and exporting country to enjoy consumption bundles of goods and services that would be unobtainable without trade.

--Restrictions on international trade hurt the importing firms, the consumers of imports, the domestic exporting firms, and even the non-exporting firms. Protecting domestic industry from international competition backfires: i) it increases the relative price that other countries pay for domestically produced goods and services that are exported; ii) it raises the price of the imported goods consumed by domestic consumers; and iii) it lowers the income of producers of the goods for which the country has a comparative advantage in production by more than the increase in the incomes of those industries that gain from trade restrictions. Together, these influences decrease the total demand for domestic goods and services in the country imposing trade restrictions by more than the increase in demand for those domestic goods and services in industries for which the country does not have a comparative advantage.

--International trade is a “win-win” situation for all countries involved in trade. This is the most important message that can be delivered from this chapter. All legitimate counterpoints are rooted in the concern over unequal distributions of the gains from trade that are created. Emphasize that economic efficiency and economic prosperity can be achieved only through free trade among nations, and that the surplus generated is more than sufficient to reimburse those individuals whose lives are made worse off from free trade. Point out that the difficulties of implementing such a reimbursement program are what prevent such programs from being established on a large scale.

--There is no good economic argument in support of trade restrictions. Dispel the many myths surrounding various justifications for imposing trade restrictions. The section of the chapter entitled “Cases Against Protection” contains concise and complete counter-arguments to the often heard justifications for restraining international trade. Emphasize that economists overwhelmingly agree that there is no good argument against free trade.

The chapter ends with a new Economics in the News on the impacts of putting a tariff on Mexican products in order to pay for a proposed border wall. It focuses on the economic impact of such a tariff and who would actually pay the cost are the focus of the analysis.

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Additional Problems 1.

Suppose that the world price of bananas is 18 U.S. cents a pound and that when Australia does not trade bananas internationally, their equilibrium price in Australia is 12 U.S. cents a pound. If Australia opens up to international trade, does it export or import bananas?

Explain how the price of bananas in Australia changes. How does the quantity of bananas consumed in Australia change? How does the quantity of bananas grown in Australia change?

2.

Suppose that in response to huge job losses in the U.S. textile industry, Congress imposes a 100 percent tariff on imports of textiles from China. a. Explain how the tariff on textiles will change the price of textiles, the quantity of textiles imported, and the quantity of textiles produced in the United States. b. Explain how the U.S. and Chinese gains from trade will change. Who in the United States will lose and who will gain?

3.

In the 1950s, Ford and General Motors established a small car-producing industry in Australia and argued for a high tariff on car imports. The tariff has remained through the years. Until 2000, the tariff was 22.5 percent. What might have been Ford’s and General Motor’s argument for the high tariff? Is the tariff the best way to achieve the goals of the argument?

4.

Use the information below to answer the following question U.S. Expands China Paper Anti-Dumping Tariff Responding to a case brought by the NewPage Corporation of Dayton, Ohio, the U.S. Commerce Department announced it was imposing a tariff of 99.65 percent on imported glossy paper from China. Glossy paper is the type of paper used to manufacture art books, high-end magazines, textbooks, and annual reports. In 2006 imports of glossy paper from China was estimated to be $224 million.

Reuters, May 30, 2007 a. What is dumping? Who in the United States loses from China’s dumping of glossy paper? b. What argument might NewPage Corp. have used to persuade the U.S. Commerce Department to impose a 99.65 percent tariff? c. Explain who, in the United States, will gain and who will lose from the tariff on glossy paper. How do you expect the prices of magazines and textbooks that you buy to change?

Solutions to Additional Problems 1.

2.

With no international trade, the price in Australia is less than that in the world, so Australia has a comparative advantage in producing bananas. As a result, if Australia opens up to international trade, it will export bananas. With international trade, the price of bananas in Australia rises. The higher price leads to a decrease in the quantity of bananas consumed in Australia. The higher price also leads to an increase in the quantity of bananas grown in Australia. a.

Higher tariffs increase the price U.S. consumers pay for textiles imported from China. Because the price of Chinese imported textiles rises, the quantity imported decreases. The quantity of textiles produced in the United States increases.

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b.

3.

4.

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This trade restriction means that the U.S. and Chinese gains from trade definitely decrease. Textile workers and owners of textile firms will gain from the higher price. Textile consumers will lose from the higher price.

Most likely the argument in favor of the tariff was the infant-industry argument. According to proponents of this argument, protection is necessary to a new industry to enable it to grow into a mature industry that can compete in world markets. Alternatively, Ford and General Motors might also have argued that a high tariff was necessary to protect Australian jobs. Protection is not the best way to achieve these goals. A more efficient way to protect infant industries is to subsidize the firms in the industry. And the jobs lost in the auto sector will be regained in other sectors devoted to exporting Australian goods.

a. b.

c.

Dumping is when a foreign firm sells its exports at a lower price than the cost of production. U.S. producers of glossy paper lose from China’s dumping of glossy paper.

Dumping is illegal under the rules of international trade, so dumping is regarded as a justifiable reason for a temporary tariff. NewPage might have argued that Chinese exporters of glossy paper were charging a price of (approximately) one half the cost of production. In this case a tariff of 99.65 percent will (approximately) double the U.S. price of the imported glossy paper, thereby raising the price to the (alleged) cost of production.

The U.S. producers of glossy paper (such as NewPage!) will gain. The U.S. government also will gain because it will receive additional tariff revenue. U.S. consumers of glossy paper will lose. The higher price of glossy paper increases the costs of magazine and textbook publishers. The supply of magazines and textbooks decreases so their price rises.

Additional Discussion Questions 1.

How can we know that the benefits to the economy from free trade are greater than the benefits accruing to the domestic industry that is protected from foreign competition?

Stress to the students that if unrestrained international trade creates the efficient outcome for both countries involved, it also must mean that prosperity for each country is maximized.

• Emphasize that free trade between nations encourages each country to pursue specialization in production in those industries for which the country has a comparative advantage relative to other countries.

• If the total quantity of goods and services consumed in each country after international trade is greater than without international trade, then total incomes accruing to individuals must be greater, which means the prosperity of each nation’s economy as a whole is greater under free trade.

2.

How will countries know which domestic industries have a comparative advantage in order to allocate resources towards specialization in producing those goods and services? Specialization and gains from international trade will arise naturally through relative price changes on the world market.

• When domestic firms within an industry have a lower opportunity cost of production than firms in other countries, these firms discover that the price they can receive from foreign buyers (importers from other countries) is higher than the price they can receive from domestic consumers. In other words, the domestic price before international trade is lower than the world price. These domestic firms increase output, demand more labor, capital, and raw materials, and resources flow toward these industries. .

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•

•

When domestic firms within an industry have a higher opportunity cost of production than firms in other countries, domestic consumers discover that the price they must pay to foreign sellers for a good is lower than the price they must pay domestic producers. Domestic consumers switch their purchases to foreign imports. The domestic firms producing this good decrease their production, decrease their use of labor, capital, and raw materials, and resources flow away from these firms.

Each country’s economy naturally becomes specialized in producing output in those industries for which the country enjoys a comparative advantage. However, for each country to gain, each country must allow consumers and producers to have free access to foreign markets.

3.

Shouldn’t we protect the workers of those industries that are hurt by foreign competition? Point out that protecting the workers in industries for which our country does not have a comparative advantage is akin to making everyone in the economy suffer a lower level of prosperity than under unrestricted trade—all to ensure that a small minority of people does not suffer the economic losses associated with relocating to another community and finding employment in another industry. Use some specific examples in recent history: • If Congress imposes import quotas on Japanese vehicles being imported into the United States, tens of thousands of American autoworkers would be forced to find employment in another industry. Compare this to the tens of millions of car buyers each year that must pay hundreds or even thousands of extra dollars for their cars.

• In 2002, President George W. Bush signed into law a tariff on foreign steel by some 30 percent. He effectively cost the hundreds of millions of American consumers tens of billions of dollars in higher prices for the myriad of goods containing steel, as well as those goods and services requiring transportation in trucks, trains, airplanes, and ships that are made from steel. He did this seeking political support from those states with a large presence of steel workers who work for firms that could not make a profit at the unregulated world market price of steel. The president’s defense was that other nation’s steel industries were receiving subsidies and had an “unfair “ advantage in production costs, effectively “dumping” steel in the U.S. markets at prices below production costs. Ask the students: What is “unfair” about having foreign governments effectively subsidizing the purchase of automobiles, trucks, and rail and air transportation by hundreds of millions of American citizens? Point out it is only “unfair” to the tens of thousands of steel workers who stand to face job relocation costs of finding work in another industry.

• Emphasize that in each of these cases of trade restrictions, the economy as a whole would have gained from free international trade, even if autoworkers and steel workers lost some jobs. When we protect steel, or timber, or sugar, there are many more jobs in the downstream industries that use these inputs than there are jobs being protected.

Higher costs limit expansion for those downstream industries. So why do they get protection? Autoworkers and steel workers are groups of people that are much more easily organized and stand to benefit much more individually from trade restrictions than the wide-spread American consumers. The result is successful lobbying efforts to restrict trade to the detriment to all consumers in the American economy.

4.

Discuss the following: Adam Smith told British politicians in the 18th century that they shouldn’t focus so much on producers. Free trade is not about importing so that others will take our exports. The argument “seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce.” But .

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“consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to only so far as it may be necessary for promoting that of the consumer,” according to Smith.

This idea will have applications as the class studies perfect competition. In the end, competition means that firms make only a normal return and society’s resources are allocated efficiently.

5.

The first months of the Trump Administration have already brought numerous examples that could be used as classroom case studies and the basis for discussion. One theme is whether it is better to pursue multilateral agreements or to negotiate with each trading partner separately. Revisiting the terms of existing agreements, such as NAFTA, has also been proposed. Imposing steel tariffs based on national security rather than other arguments has been considered. Each day’s news will probably offer examples that re-consider the arguments about whether trade is a zero-sum game and what policies are in the best interests of the United States..

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UTILITY AND DEMAND

The Big Picture Where we have been: Chapter 8 uses marginal utility theory to derive the downward-sloping demand curve introduced in Chapter 3 (and used throughout Chapters 4 to 7). Utility theory will also further explain the factors that change demand. Consumer surplus has been used in multiple chapters and will be reinforced in this chapter to help explain the diamond-water paradox and the difference between total utility and marginal utility.

Where we are going: Chapter 9 presents a parallel analysis of the consumer problem using indifference curves.

Each chapter is self-contained, so either can be omitted. Marginal analysis is used in this chapter to describe marginal utility and the utility maximizing choice for consumers. The importance of marginal analysis will be reinforced in future chapters as we move through profit maximization and choice making in factor markets. Chapter 19, which deals with risk, uses some of the concepts from this chapter, although Chapter 19 also is self-contained.

New in the Thirteenth Edition The chapter introduction has been updated to focus on streaming movies. The data in the Economics in Action case study on maximizing utility from downloading music have been updated and now cover the growth in streaming music. The example calculates consumer surplus both from downloads and from streaming. The Economics in the news analysis at the end of the chapter compares unlimited data plans, common in the United States, with purchased data plans, the only kind available in Canada. Using the data in the article, the analysis considers who gets the better deal.

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Lecture Notes

Utility and Demand • • •

I.

Economists assume that people behave to make themselves as well off as possible.

Consumption possibilities tell us what the consumer can afford to buy given a limited income and the prices of the goods and services they are considering.

Preferences are reflected in the discussion of utility maximization

Consumption Choices •

Consumption possibilities are all the things a consumer can afford to buy.

The Budget Line • •

•

•

The limits of consumption possibilities are illustrated with a budget line.

The budget line marks the boundary between those combinations of goods and services that the consumer can afford to buy and those that it cannot afford.

The budget line shown illustrates the possible combinations of pizza and books that a consumer with $50 income could purchase if the price of pizzas were $10 and the price of books were $10.

The budget line constrains choices: Points on the budget line and inside the budget line are affordable and within the consumer’s consumption possibilities. Points beyond the budget line are not affordable.

Changes in Consumption Possibilities • • • •

Consumption possibilities change when income or prices change.

An increase in income shifts the budget line rightward without changing its slope.

A change in the price of one of the goods changes the intercept on its axis and changes the slope of the budget line.

These changes are used again in the alternate consumer choice model in chapter 9.

Preferences •

The choice a consumer makes depends on preferences.

Total utility •

•

Total utility is the total benefit that a person gets from the consumption of goods and services. As more of a good or service is consumed, total utility increases.

The table provides an example of utility from consuming movies and paperback books in a given week.

Quantity of movies 0 1 2 3 4 5 6

Total utility 0 24 44 72 80 84 86

Quantity of books 0 1 2 3 4 5 6

Total utility 0 20 30 38 44 48 50

Where do the utility numbers come from? Year after year, you will get this question from the curious student. While the numbers for utility are ordinal rather than cardinal, using those terms to explain utility .

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to undergraduates will generally result only in many blank stares. To help with one answer to this question, try the following story: Lisa likes movies and books. We tell Lisa that we’re going to call the utility she gets from 1 movie a month 24 units of utility. Then we ask her to tell us, using the same scale, how much she would like 2, 3, or more movies, and 1, 2, 3, or more books.

Marginal Utility •

•

Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. The table shows the marginal utility from movies.

When a good generates value, it has a positive marginal utility. Total utility increases as the quantity consumed increases.

Total utility 0

1

24

2

44

3

72

4

80

Marginal utility 24 20 18

Diminishing Marginal Utility •

Quantity of movies 0

Diminishing marginal utility is the principle that as more of a good or service is consumed, its marginal utility decreases. In the table the marginal utility diminishes as more movies are consumed.

8

II. Utility-Maximizing Choice • •

A consumer’s choices influence the total level of his or her utility because different combinations of goods generate different amounts of utility. The key assumption of marginal utility theory is that the household consumes the combination that maximizes its utility.

We have to combine the constraint imposed by the budget line with the consumer’s preferences to find the combination of products that gives the consumer the maximum available utility.

Consumer Equilibrium •

Consumer equilibrium occurs when a situation in which a consumer has allocated all available income in a way that maximizes utility given the prices of the products.

A Spreadsheet Solution •

The most direct way to find the quantity of Quantity of Total Quantity Total goods and services is to make a table with movies utility of books utility the choices available. Suppose the price of a 0 0 0 0 movie is $8, the price of a book is $4, and the 1 24 1 20 consumer has income of $24.

2 44 2 30 • Calculate the combinations of products 3 72 3 38 that exhaust the available income given 4 80 4 44 the prices of the goods. In the table, the 5 84 5 48 consumer can afford (3 movies/0 6 86 6 50 books), (2 movies/2 books), (1 movie/4 books), and (0 movies/6 books). While the consumer can also afford the combinations of products inside the budget line, the smaller quantities associated with those points would have less utility than the points on the budget line.

• From the utility figures given for each product, calculate the total utility from the combination of the two products. In the same order as the affordable combinations above, these total utilities are 72, 74, 68, and 50. Emphasize that it is total utility from the combination of the two products that the consumer is trying to maximize. .

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• • •

Select the combination that gives the maximum total utility, (2 movies/2books for total utility of 74) in this case.

While in a model we might calculate the total utility from all the possible combinations of products and then select the combination with the highest utility, this is not a likely approach for consumers in practice.

A more natural way to find the consumer equilibrium is to use marginal analysis to make the decision.

Choosing at the Margin • • •

A consumer’s utility is maximized when the consumer spends all available income and equalizes marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.

If the consumer is left with money to spend, opportunities for increasing utility are left unused, so the consumer can only be maximizing utility when all available income is spent.

The table to the Marginal Marginal right has the Quantity Marginal utility per Quantity Marginal utility per marginal utility of utility dollar of books utility dollar schedules that movies are computed 1 22 2.75 1 15 4.75 from the total 2 18 2.25 2 9 2.25 utility schedules 3 13 1.63 3 7 1.75 in the table 4 6 0.75 4 5 1.25 above. (The 5 3 0.38 5 3 0.75 marginal utilities are the averages of the two adjacent marginal utilities for each quantity.) Given the price of a movie of $8, the price of a paperback book of $4, the table also has the marginal utility per dollar schedules. Assume the consumer has $24 to allocate between movies and books. To maximize utility, the individual buys 2 movies and 2 books because that combination of movies and books spends all the available income and sets the marginal utility per dollar from a movie equal to that from a book. (Both equal 2.25.)

Do people really calculate and compare marginal utilities and prices? One of the challenges in teaching the marginal utility theory is getting the students to appreciate the fundamental role of a model of choice.

The goal is to predict choices, not to describe the thought processes that make them. Gary Becker has made the following point, updating the reference to the pitcher (from Parkin, Economics, first edition, 1990, p. 154): Justin Verlander (or substitute a currently hot pitcher) unanimously won the 2011 Cy Young award for the American League. He effectively knows all the laws of motion, of hand-eye coordination, about the speed of the bat and ball, and so on. He’s in fact solving a complicated physics problem when he steps up to pitch, but obviously he doesn’t have to know physics to do that. Likewise, when people solve economic problems rationally they’re really not thinking, “Well, I have this budget and I read this textbook and I look at my marginal utilities and the prices and determine what maximizes my utility.” People don’t do that, but it doesn’t mean they’re not being rational. Just because a Cy Young Award winner isn’t Albert Einstein doesn’t mean he can’t make rational decisions about pitching.

•

The rule to spend all income and equalize marginal utility per dollar from each good maximizes utility because anytime the marginal utility per dollar from one good exceeds that of another good, the consumer can increase his or her total utility by spending a dollar less on the good with the lower marginal utility per dollar and spending the dollar on the good with the higher marginal utility per dollar.

Counterexamples can help. To help the students see that maximizing total utility requires equalizing the .

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marginal utility per dollar on each good, work with the case when they are not equal. Suppose the marginal utility per dollar from a movie is 20 and the marginal utility per dollar from a soda is 10. Ask “If you gained an additional dollar, what would you spend it on and by how much would your total utility increase?” The students will spend it on movies and their total utility will rise by 20. Now ask the students “If you lost a dollar, what you cut back on and how much would your total utility decrease?” The students will cut back on sodas and their total utility will fall by 10. Now tell the students that they can gain a dollar by cutting back a dollar on sodas. Ask them the net change in their total utility, which is +10. The point to make is that anytime the marginal utility per dollar from one good differs from that for another good, consumption can be rearranged by cutting back on the good with the low marginal utility per dollar and spending the dollar on the good with the high marginal utility per dollar and increasing total utility.

Why don’t consumers simply choose the goods with the highest marginal utility? Students will find it relatively easy to simply memorize the rule that maximizing utility requires that the marginal utility per dollar is equal across all goods, but, intuitively, students still often expect marginal utility to be the only determinant of utility maximization. To provide some additional intuition, ask them to think about two goods they’re trying to choose between, like a new shirt and a new download of a song. Say a new shirt would have a marginal utility of 20, while the download would have a marginal utility of 1. The price of a new shirt is $30, while the price of the download is $1. Should you purchase the new shirt because it has a higher marginal utility? No! You may prefer the shirt, but it costs thirty times as much as the download.

Even though the download has the lower marginal utility, it has a higher marginal utility per dollar (1 as opposed to 2/3).

The Power of Marginal Analysis • •

The goal of maximizing utility does not require a computer and spreadsheet, but simply comparing the marginal utility per dollar of each of the products.

In the example the person’s choice between movies and books, the person maximizes his or her utility where the marginal utility per dollar from movies is equal to the marginal utility per dollar from books. Mathematically, this is represented by the equation: MU Movie MU Book . = PMovie PBook

Other applications of marginal reasoning. Help your students to appreciate that marginal reasoning is one of the most important tools for understanding the economic perspective. Remind them that we have been using marginal reasoning for many chapters now: In Chapter 2 we derived the marginal cost of production from the PPF. In Chapter 5 we discovered that competitive equilibrium is efficient because marginal social benefit (from the demand curve) equals the marginal social cost (from the supply curve).

In this chapter, we discover that equating the marginal utility per dollar across all goods and services maximizes a consumer’s utility. More generally, marginal analysis shows that if the marginal gain from an action exceeds the marginal loss, take the action.

Revealing Preference • •

We don’t have to ask a consumer to state preferences because we can figure them out by observing what is purchased at various prices.

The units we use to measure preference don’t matter. Any arbitrary unit will work; for instance, if utility is multiplied by 2, the marginal utility per dollar equation shows that the equilibrium consumption bundle does not change.

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III. Predictions of Marginal Utility Theory

Marginal utility theory predicts the law of demand. It also predicts that a decrease in the price of a substitute good increases the demand for the good; and, for a normal good, an increase in income increases demand.

A Fall in the Price of a Movie A Change in the Quantity Demanded •

If the price of a good falls and other things remain the same, the marginal utility per dollar from that good rises. As a result, the consumer increases his or her purchases of that good in order to maximize utility. (As more of the good is purchased, its marginal utility decreases; as less of other goods are purchased, their marginal utilities increase. Eventually the consumer reaches a new equilibrium at which the marginal utility per dollar for all the goods is equal.)

A Change in Demand •

When the price of a good falls, it will have an impact on the demand for related goods (substitutes and complements in consumption). In the example above, when movie prices fall, the demand for paperback books decreases, implying that movies and books are substitute goods.

A Rise in Income •

If a consumer’s income increases, the consumer will reach a new consumer equilibrium in which all the income is spent and the marginal utility per dollar from all goods is equal. Marginal utility theory predicts that as the consumer’s income increases, the demand for normal goods increases and the demand for inferior goods decreases.

Paradox of Value • •

•

The paradox of value is that water, which is essential to life, costs little, but diamonds, which are useless in comparison to water, are expensive.

The resolution to this paradox comes from distinguishing total utility from marginal utility. The total utility from water is much more than from diamonds. But we have so much water that its marginal utility is small. And we have so few diamonds that their marginal utility is high. When a household maximizes its utility, it makes the marginal utility per dollar equal for all goods. Because diamonds have a high marginal utility, they have a high price. Because water has a low marginal utility, it has a low price.

Consumer surplus also can be used to resolve the paradox as well. The consumer surplus from consuming water is vast but the consumer surplus from consuming diamonds is small.

Temperature as an Analogy • • •

Temperature and utility are both abstract concepts.

The concept of utility allows economists to make predictions about human choices just as temperature allows predictions of physical phenomena.

Utility may not be as precise a thermometer in making some types of predictions but is still useful.

An Economics in Action case considers the utility from recorded music and looks at the growth of streaming as an alternate way to obtain music. It compares the consumer surplus obtained from downloads with that obtained from streaming.

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IV. New Ways of Explaining Consumer Choices Behavioral Economics •

Behavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influences economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work.

• There are three impediments to rational choice: bounded rationality, bounded will-power, and bounded self-interest.

Prudential Financial has a number of interesting neuroscience experiments that are often used for their advertisements but are available with the background science on You Tube. For example, the marshmallow experiment about delayed gratification is available at https://www.youtube.com/watch?v=sT7fbayfNBU.

Bounded Rationality •

Bounded rationality is rationality that is bounded by the computing power of the human brain.

Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.

Bounded Willpower •

Bounded willpower is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.

Bounded Self-Interest •

Bounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others.

The Endowment Effect •

The endowment effect is the tendency for people to value something more highly simply because they own it.

Endowment effect in the housing market: The housing market entered a severe slump in the late 2000s and took years to even begin to emerge. One factor might have been the endowment effect: The price that home buyers were willing to pay for a house is lower than what homeowners, with the endowment effect, believe their home is worth. Consequently homes might sit on the market for long periods of time.

Neuroeconomics •

Neuroeconomics is the study of the activity of the human brain when a person makes an economic decision. Different decisions appear to activate different areas of the brain. Some decisions are made in the pre-frontal cortex, which is where memories are stored and data are analyzed. These decisions might be deemed rational. Other decisions are made in the hippocampus, which is where memories of anxiety and fear are stored. These decisions might be deemed irrational.

Controversy •

Whether economics should focus on explaining the decisions we observe or on what goes on inside people’s heads is the source of controversy.

Are unlimited data plans the best deal for consumers? The chapter closes with an Economics in the News analysis that considers this question using data on U.S. plans, which now often include unlimited data, with Canadian plans, where unlimited data plans are not available.

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Additional Problems 1.

Mary enjoys classical CDs and Quantity Total utility from Total utility from travel books and spends $50 a per month classical CDs travel books month on them. The table shows 1 30 30 the utility she gets from each good.

2 40 38 a. Compare the two utility 3 48 44 schedules. Can you say anything 4 54 46 about Mary’s preferences?

5 58 47 b. What do the two utility schedules tell you about Mary’s preferences? c. If a classical CD and a travel book cost $10 each, how does Mary spend the $50 a month?

2.

Rob enjoys rock concerts and the opera. The table shows the marginal utility he gets from each activity. Rob has $100 a month to spend on concerts. A rock concert ticket is $20, and an opera ticket is $10. How many rock concerts and how many operas does he attend?

Concerts per month 1 2 3 4 5

Marginal utility from rock concerts 90 80 60 40 20

Marginal utility from operas 120 90 60 30 20

3.

In problem 2, Rob’s uncle gives him $30 to spend on concert tickets, so he now has $130. How many rock concerts and how many operas does he attend now that he has $130 to spend?

4.

In problem 2, if the price of a rock concert decreases to $10, how many rock concerts and operas will Rob attend?

Solutions to Additional Problems 1.

a.

b.

c.

2.

Mary gets the same utility from 1 classical CD as from 1 travel book, but at quantities greater than 1 she gets more utility from any number of classical CDs than she does from the same number of travel books.

Mary receives the same marginal utility from her first classical CD as from her first travel book. At quantities greater than 1, Mary gets more marginal utility from an additional classical CD than she gets from an additional travel book when she has the same number of each.

Mary buys 3 classical CDs and 2 travel books.

When Mary buys 3 classical CDs and 2 travel books she spends $50. Mary maximizes her utility when she spends all of her money and the marginal utility per dollar from classical CDs and travel books is the same. When Mary buys 3 classical CDs her marginal utility per dollar spent is 0.8 units per dollar and when Mary buys 2 travel books her marginal utility per dollar spent is 0.8 units per dollar.

To maximize his utility, Rob attends 3 rock concerts and 4 opera concerts.

Rob will spend his $100 such that all of the $100 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 3 rock concerts and 4 operas, he spends $60 on rock concerts and $40 on operas—a total of $100.

The marginal utility from the third rock concert is 60 and a rock concert ticket is $20, so the marginal utility per dollar from rock concerts is 3. The marginal utility from the fourth opera is 30 and an .

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opera ticket is $10, so the marginal utility per dollar from operas is 3. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

3.

To maximize his utility, Rob attends 4 rock concerts and 5 operas.

Rob will spend his $130 such that all of the $130 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 4 rock concerts and 5 operas, he spends $80 on rock concert tickets and $50 on operas—a total of $130.

The marginal utility from the fourth rock concert is 40 and a rock concert ticket is $20, so the marginal utility per dollar from rock concerts is 2. The marginal utility from the fifth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from opera is 2. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

4.

To maximize his utility, Rob attends 5 rock concerts and 5 operas.

Rob will spend his $100 such that all of the $100 is spent and that the marginal utility per dollar from each type of concert is the same. When Rob attends 5 rock concerts and 5 operas, he spends $50 on rock concert tickets and $50 on opera tickets—a total of $100.

The marginal utility from the fifth rock concert is 20 and a rock concert ticket is $10, so the marginal utility per dollar from rock concerts is 2. The marginal utility from the fifth opera is 20 and an opera ticket is $10, so the marginal utility per dollar from operas is 2. The marginal utility per dollar from rock concerts equals the marginal utility per dollar from operas.

Additional Discussion Questions 1.

Have you ever eaten or drank “too much”? Use the students’ personal experience with food or drink to show them that the marginal utility for a good can be increasing, diminishing, or even negative. The example works well for many types of food and drink consumption, but college students often especially enjoy sharing their experiences (or their friends’ experiences) with alcohol.

Can alcohol consumption exhibit increasing marginal utility? The first drink may not induce the euphoric feeling that many students seek, but two drinks might, with the third drink increasing the euphoria even more than the second drink. In this range of consumption, the student experiences increasing marginal utility. Point out that this increasing marginal utility isn’t likely to last forever.

Can alcohol exhibit diminishing marginal utility? By the fourth or fifth drink of the evening, the additional euphoria from each drink is not as much as the prior drink, meaning the student is in the zone of diminishing marginal utility.

Can alcohol exhibit negative marginal utility? After the fifth or sixth drink for the evening, most students quickly feel the discomfort of intoxication and suffer a significant decline in euphoria mixed with a significant increase in discomfort and disorientation.

Continued consumption of alcohol can eventually bring the onset of alcohol poisoning, when the body starts to reject further intake of alcohol by ejecting the excess alcohol. Most students would agree that, at that point, an additional drink would generate negative marginal utility.

2.

If the Surgeon General (and the American Medical Association) concludes that moderate wine and beer consumption can have a positive influence on cardiovascular health, how will utility and demand be affected? Ask the students to use utility theory to explain how changes in the marginal utility of beer and wine consumption will cause the demand for beer and wine to increase, despite unchanged short-run prices or consumer incomes. .

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Would people voluntarily pay for something seemingly undesirable? Get students to see that the utility they get from one good is oftentimes dependent on the level of other goods and services consumed. Ask the students to use utility theory to explain: 1) Why do people regularly put themselves through undesirable, rigorous exercise programs? (better health increases our marginal utility of engaging in other activities) 2) Why do students forgo lots of leisure time to take college classes? (better education increases our appreciation of the world and allows us make better choices in our lives) Help the students see that consumers invest in apparently undesirable goods the same way society invests in capital to increase future consumption—except it is human capital that consumers are investing in.

4.

How could utility theory help us understand the difference between a federal income tax and a federal sales tax on consumer consumption patterns? This is a real-world application of utility theory designed to boost student confidence.

• Mention that federal sales tax proponents point out that sales taxes do not penalize savings whereas income taxes penalize both savings and consumption, motivating consumers to save less and consume more.

• Recall how Chapter 2 used the production possibilities frontier model to show that higher present consumption and lower present investment (which is largely based on savings) decreases future consumption for society through slower economic growth.

• Explain how consumers allocate their income across affordable consumption and savings combinations by equating the ratio of marginal utility per dollar for both. If the same tax revenue was collected by a federal sales tax rather than the income tax, the tax price for savings would decrease and the tax price for consumption would increase.

(Make sure you explain that “savings” is an example of a “good.” In the examples used in the text, there is no savings. All income is spent on goods. When savings exists, not all of a consumer’s income is spent, but all of the income is allocated to either consumption goods or savings.)

• Show how consumers adjust these ratios by increasing the marginal utility of consumption through less consumption and decreasing the marginal utility of savings by saving more. Utility is maximized at a higher level of savings when consumption is penalized through a consumption tax instead of an income tax.

5.

How does utility theory differentiate a “need” from a “want”? If you are really in the mood for a very heated discussion on utility analysis, just ask the students what the marginal utility function for a “necessity” looks like. The students should recognize that it is perfectly vertical, where no increase in price is sufficiently large to cause the person to decrease consumption of a necessity in order to equate the marginal utility per dollar ratios across all goods and services. All income is spent on necessity until the consumer is sated, and remaining income is allocated across goods and services until the marginal utility per dollar ratios equalize. (This type of a utility function reflects lexicographic preference orderings.)

Is a vertical utility function a reasonable outcome to expect for any good, even medicine or food? Point out that even the poorest of people allocate their meager incomes across more than just one good or service (the necessities). Somehow the income is allocated despite the supposed vertical marginal utility curve.

How is income allocated across multiple “necessities” if all have vertical marginal utility functions? Point out that if there is more than one “necessity,” then there is more .

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than one marginal utility function involved in allocating income. Help students to recognize that because in the real world the poor allocate their income across multiple goods, then the marginal utility per dollar ratios involved cannot be vertical, but they may be very steep.

Emphasize that for these consumers to maximize their utilities, each of the marginal utility per dollar ratios will need to be equalized, making the income allocation process indistinguishable from mere “wants.”

Is it even meaningful to differentiate needs from wants among multiple goods or services? There is no positive answer to this question—only a normative one. Utility analysis has just proven that there is no positive definition of a necessity. Now step back and let the sparks fly!

6.

It is often difficult to create incentives for behavior that is very good for us in the long run but not necessarily pleasurable in the short run (studying, eating right, and exercising) and disincentives for activities that lead to future pain but present pleasure (smoking, eating whatever is convenient and tasty, sleeping through class). Have students suggest possible incentives/disincentives that they think might address this problem. Attendance and being prepared for class, eating right and moving more, and all kinds of other things promote our long run best interests but we live in world where diabetes is a growth industry and where many students think that access to notes in classroom technology packages means they don’t need to attend or read the book. What do they think would work, both personally and at the level of social policy? How does this relate to marginal utility theory?

7.

Type 2 Diabetes is often related to poor diets and lack of exercise. If it is avoidable, how does the material in this chapter help us understand why it is on the rise around the world? The answer to this question might well be related to bounded rationality.

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C h a p t e r

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POSSIBILITES, PREFERENCES, AND CHOICES

The Big Picture Where we have been: This chapter, along with Chapter 8, examines the consumer choices that underlie the law of demand. Budget lines were introduced in Chapter 8 and are more fully explored in this chapter. This chapter shows how the substitution effect combined with the income effect for a normal good always leads to the downward-sloping demand curve, which was assumed in Chapter 3. The concept of slope, as explained in Chapter 1 (appendix), is used to show that in equilibrium the MRS equals the relative price of the goods.

Where we are going: Chapters 10 and 11 study the theory of the firm and the firm’s costs, and Chapters 12 through 15 look at firm behavior in different market structures.

New in the Thirteenth Edition The material in this chapter is similar to the last edition, but the case studies have been updated.

The chapter opener considers why video streaming hasn’t completely replaced movie theaters and why it is taking students longer to complete college degrees, both of which are addressed in later examples. The Economics in Action has been updated and expanded to include video streaming as an option. The Economics in News analysis considers how rising costs for college have made some students take longer to finish their degrees.

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Lecture Notes

Possibilities, Preferences, and Choices • •

I.

A person’s budget in combination with his or her preferences determines what goods and services the person consumes.

Using the budget line and indifference curves, economists can predict how changes in the price of a good or service affect the quantity a person demands.

Consumption Possibilities • •

• •

A household’s consumption choices are constrained by its income and the prices of the goods and services available. A household’s budget line describes the limits to its consumption choices.

The figure to the right shows a budget line for a household that buys only pizzas and books. The household can buy any combination of pizza and books that lies on or within the budget line.

Combinations that lie beyond the budget line are unaffordable.

Divisible goods can be bought in any quantity and we can best understand household choices if we assume all goods are divisible.

The budget line illustrates a constraint on choices.

Any point on or inside the line can be purchased.

Any point outside the line is unaffordable and cannot be purchased.

Budget Equation • •

•

•

•

•

We can describe the budget line by using a budget equation, which states that income equals expenditure.

Calling the price of a book PB, the quantity of books QB, the price of a pizza PP, the quantity of pizza QP, and income Y, we can write a budget equation as PB  QB + PP  QP = Y, which can be rearranged into slope-intercept form as QB = Y/PB − (PP /PB )  QP. A household’s real income is the household’s income expressed as a quantity of goods the household can afford to buy. In the figure above, in terms of books, the household’s real income is Y/PB (5 books), which is the vertical intercept of the budget line.

A relative price is the price of one good divided by the price of another good. The magnitude of the slope of the budget line, (PP /PB ), is the relative price of a pizza in terms of a book. A relative price is an opportunity cost, so the relative price of a pizza in terms of books gives the opportunity cost of a pizza in terms of books forgone.

When the price of the good measured along the horizontal axis (pizzas) changes, the budget line rotates around the vertical intercept. If the price of the good falls, the budget line rotates outward and becomes flatter; if the price of the good rises, the budget line rotates inward and becomes steeper.

When income changes, the budget line shifts and its slope does not change. If income increases, the budget line shifts outward; if income decreases, the budget line shifts inward.

Example: The budget line as a menu. Emphasize that the consumer’s budget line is like that part of a menu that delineates all affordable combinations of food and drinks that are available to the consumer given a budget.

If you want to push this analogy, have the students assign a price to each of the two goods and then choose .

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a level of income to be spent on the dinner. Draw the budget line and then have the students show how a rise in the price of drinks or the price of food would rotate the budget line and change relative prices. Then have the students help you illustrate how an increase in income shifts the budget line allowing more food (perhaps dessert) and the second glass of wine.

II. Preferences and Indifference Curves • •

A preference map shows how a person ranks various combinations of goods and services.

Indifference curves are used to illustrate a person’s preference map. An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. The figure to the right shows three of a person’s indifference curves between pizza and books.

• By construction the consumer is indifferent among all the points on any particular indifference curve.

• The consumer prefers points above any particular indifference curve to points on the curve. And the consumer prefers points on the indifference curve to points below the curve. In the figure, the consumer prefers any point on indifference curve I2 to any point on I1 and any point on I3 to any point on I2.

Marginal Rate of Substitution •

The marginal rate of substitution (MRS) is the rate at which a person will give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and at the same time remaining indifferent (remaining on the same indifference curve).

• The magnitude of the slope of the indifference curve at any point measures the marginal rate of substitution between the goods. If the indifference curve is steep, the MRS is high; if the indifference curve is flat, the MRS is small.

• The diminishing marginal rate of substitution is the general tendency for a person to be willing to give up less of good y to get one unit of good x, and at the same time remain indifferent, as the quantity of x increases. This principle implies that indifference curves generally become flatter moving along them to the right.

Degree of Substitutability • • •

The indifference curves between most goods are bowed in, with a diminishing MRS. The indifference curves for perfect substitutes are linear, with a constant MRS. The indifference curves for perfect complements are L-shaped. Utility increases (the consumer moves to a higher indifference curve) only if the quantity of both goods x and y increases.

Perfect substitutes or just substitutes? Students will remember discussions of substitutes and complements in consumption from Chapter 3, and often don’t see how “perfect” substitutes or complements are any different. Be sure to use examples to show how, even for most goods that are considered substitutes (or complements), the MRS will still be diminishing. Only when a consumer’s willingness to trade one good for the other is constant (i.e., MRS is linear) are two goods considered “perfect” substitutes. Similarly, you may drink cream in your coffee, implying coffee and cream are complements, but they’re not likely to be “perfect” complements. A cup of coffee without cream may still be better (increase your utility) than no coffee at all.

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III. Predicting Consumer Choices Best Affordable Choice •

•

The consumer will select his or her best affordable point. This point: • is on the budget line, • is on the highest attainable indifference curve, • has a marginal rate of substitution between the two goods equal to the relative price of the two goods.

The figure shows the best affordable point, 2 pizzas and 3 books. This combination is on the budget, and hence is “affordable.” It also is on the highest indifference curve so that the marginal rate of substitution equals the relative price of the two goods, and hence the point is “best.”

The meaning of tangency. Emphasize to your students the meaning behind the tangency point between the indifference curve and the budget line. In particular, the marginal rate of substitution (MRS) shows the consumer’s willingness to give up one good to get more of the other good. The relative price of the two goods shows what the consumer must give up one good to get more of the other good. When a consumer equates the marginal rate of substitution (MRS) to the relative price ratio, the consumer is just willing to give up what he or she must give up, and there are no unrealized gains from substituting one good for another.

A Change In Price • •

•

The price effect shows how a change in the price of a good affects the quantity consumed of that good.

When the price of the good on the x-axis falls, the budget line rotates around the y-axis intercept and becomes flatter. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: It is on the new budget line, it is on the highest attainable indifference curve, and the MRS equals the slope of the new budget line.

When the price of a good changes, tracking the change in the quantity of the good consumed reveals the demand curve for that good.

The Economics in Action case study considers how the best affordable combination of movies, DVD rentals, and video streaming have changed over time, largely due to changes in prices, first in the DVD rental market and now with Netflix and video streaming. Have students illustrate this result for themselves, shifting the budget line between movies and streaming and seeing what the new equilibrium might look like.

A Change In Income • •

•

The income effect shows how a change in income affects the buying plans of consumers.

When the price of the goods remains constant, a change in income shifts the budget line. This shift changes which indifference curve is highest attainable indifference curve. The person moves to a new consumption point. The new consumption bundle satisfies all three properties: it is on the new budget line; it is on the highest attainable indifference curve; and the MRS equals the slope of the new budget line.

A change in income shifts the demand curve, because a different quantity is consumed at the same prices. .

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If income rises and more is consumed at each price (or if income falls and less is consumed at each price) the good is a normal good.

Substitution Effect and Income Effect •

For a normal good, a rise in price always decreases the quantity consumed. This result is shown by breaking the price effect into two parts, as illustrated in the figure in which the price of movies rise: • The substitution effect is the effect of a change in price on the quantity bought when the consumer (hypothetically) remains indifferent between the original situation and the new one. The substitution effect is showing by moving the new budget line (with its new slope) so that it is tangent to the initial indifference curve. This procedure creates a (hypothetical) new best affordable point using the initial indifference curve and the hypothetical budget line. Comparing the initial best affordable point to this new one captures the substitution effect. In the figure this compares point a to point b. The substitution effect of a rise in price always leads to a decrease in the quantity consumed.

• The income effect is the effect on the quantity bought of a change in income sufficient to shift the hypothetical budget line used to measure the substitution effect, so that it is the same as the actual new budget line. This process is the movement from point b to point d in the figure.

For a rise in price, this change requires a decrease in income. For a normal good, the decrease in income decreases the quantity consumed. So for a normal good, the substitution effect and the income effect reinforce each other: both demonstrate that the quantity consumed decreases. For an inferior good, the decrease in income increases the quantity consumed. So for an inferior good, the substitution effect and the income effect have opposite effects on the quantity consumed. It is theoretically possible for the income effect to be large enough that the rise in the price of the good results in an increase in the quantity demanded. But such a case has not been observed in reality.

Income and substitution effects: two separate influences over demand. Income and substitution effects are typically difficult concepts for students to grasp. Be sure that the students understand how a change in a good’s price causes two separate influences on a consumer’s purchase decision: i) a higher (lower) price raises (lowers) the opportunity cost of that good, making that good less (more) attractive than all other goods; and ii) a higher (lower) price means less (more) of all goods and services is affordable, causing the quantity demanded for all normal goods to decrease (increase). A consumer may not think of each effect individually when making consumption decisions, but both effects will have an impact.

Can the income effect for an inferior good ever dominate the substitution effect? Many economists have studied the infamous potato famine in Ireland in the mid-19th century in search of the elusive “upward-sloping demand curve” associated with strongly inferior goods. Indeed, when food became even scarcer than usual in that poverty-stricken country, historical records indicate that Irish families consumed a greater quantity of potatoes as the market price of potatoes increased. Many economists were misled into thinking they had found historical evidence of the world’s first recorded positively-sloped demand curve! However, they failed to remember their basic economics: it is the relative price of potatoes .

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that is tracked on the demand curve for potatoes, not the money price. The money price of potatoes rose more slowly than the prices of other foods. This change lowered the relative price of potatoes to Irish families and so the quantity they consumed increased, in accord with the law of demand. Although some experimental evidence exists to show that demand curves with a positive slope might exist, there are no good real-world examples.

An Addendum: Relationship between MRS and MU ratios: If you’ve covered both the marginal utility theory (from Chapter 8) and indifference curve theory of consumer choice in this chapter--and you’re teaching an honors section of economics majors--you might want to spend a bit of time demonstrating the equivalence of the two sets of results. The basic analysis that you might cover is the following: In marginal utility theory, total utility is maximized when MUM /PM = MUS/PS. (the subscript M stands for movies and the subscript S stands for sodas to be consistent with the textbook example) In indifference curve theory, the consumer is at the best affordable point when the marginal rate of substitution of movies for soda equals the relative price of movies in terms of soda. That is: MRS = PM /PS These two propositions are equivalent. To see why, there are a couple of ways to explain this. If your students are particularly good at math, begin with the fact that the change in total utility can be written as: Change in Total Utility = MUM  QM + MUS  QS where  means “change in” and QM and QS are the quantities of movies and soda.

Because a consumer is indifferent between any pair of points along an indifference curve, you can think of an indifference curve as a constant utility curve. So along an indifference curve, the change in total utility is zero. When the change in total utility is zero, 0 = MUM  QM + MUS  QS, And so MUM  QM = –MUS  QS. Now divide both sides of this equation by QM and also divide both sides by MUS to obtain: QS /QM = -MUM /MUS Notice that the left-hand side of the last equation is the change in soda divided by the change in movies along an indifference curve, which is the slope of the indifference curve. But the magnitude of the slope of an indifference curve is the marginal rate of substitution. So, MRS = MUM /MUS That is, the marginal rate of substitution of movies for soda is the ratio of the marginal utilities of movies and soda.

Alternatively (or even in addition), many students appreciate an intuitive explanation of the relationship between the MRS and MUM /MUS. Simply start with the marginal utility of a movie equal to some number (20, for example). If the consumer would like a soda half as much as a movie, then the marginal utility of a soda would be 10 in that example. In that case, MUM /MUS = 20/10 = 2.

Then ask students if they could answer the following question: “How many sodas would the consumer be willing to give up for a movie?” Most students will see that the movie is worth 2 sodas. This is simply the definition of the marginal rate of substitution, and it will always be the case that the ratio of marginal utilities will be equal to the marginal rate of substitution.

Regardless of the method you use to show that MRS = MUM /MUS, the main point is that the consumer chooses the best affordable point by making the MRS equal the relative price. But that is the same as MUM /MUS = PM /PS. Multiply both sides of this equation by MUS and divide both sides by PM to obtain the marginal utility theory proposition: MUM /PM = MUS /PS.

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Economics in the News at the end of the chapter considers why it is taking students longer to finish college and focuses especially on the impact of higher college costs on students’ behavior.

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Additional Problems 1.

Marc has an income of $20 per week. Root beer costs $5 a can and CDs cost $10 each. Figure 9.1 illustrates his preferences. a. What are the quantities of root beer and CDs that Marc buys? b. What is Marc’s marginal rate of substitution of CDs for root beer at the point at which he consumes?

2.

Now suppose that in the situation described in problem 1, the price of a CD falls to $5 and the price of root beer and Marc’s income remain constant. a. Find the new quantities of root beer and CDs that Marc buys. b. Find two points on Marc’s demand curve for CDs. c. Find the substitution effect of the price change. d. Find the income effect of the price change. e. Are CDs a normal good or an inferior good for Marc?

3.

Pete buys tuna and golf balls. The price of tuna is $2 a can, and the price of a golf ball is $1.

Each month, Pete spends all of his income and buys 20 cans of tuna and 40 golf balls. Next month, the price of tuna will rise to $3 a can and the price of a golf ball will fall to 50¢.

Assume that Pete’s preference map shows indifference curves have a bowed in shape so that they show a diminishing marginal rate of substitution. a. Will Pete be able to buy 20 cans of tuna and 40 golf balls next month? b. Will Pete want to buy 20 cans of tuna and 40 golf balls? c. Which situation does Pete prefer: tuna at $2 a can and golf balls at $1 each or tuna at $3 a can and golf balls at 50¢ each? d. If Pete changes the quantities that he buys, which good will he buy more of and which less of? e. When the prices change next month, will there be an income effect and a substitution effect at work or just one of them?

4.

The sales tax is a tax on goods. Some people say that a consumption tax, a tax on both goods and services, would be better. Explain and illustrate with a graph what would happen if we replaced the sales tax with a consumption tax to a. The relative price of books and haircuts. b. The budget line showing the quantities of books and haircuts you can afford to buy. c. Your purchases of books and haircuts.

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Solutions to Additional Problems 1.

a.

b.

2.

a.

Marc buys 1 can of root beer and 3 CDs. Draw the new budget line on the graph with Marc’s indifference curves. The budget line now runs from 4 CDs on the x-axis to 4 cans of root beer on the y-axis. The new budget line is tangential to indifference curve I1 at 1 can of root beer and 3 CDs. The indifference curve I1 is the highest indifference curve that Marc can now get attain.

b.

Two points on Marc’s demand curve for CDs are the following: At $10 a CD, Marc buys 1 CD. At $5 a CD, Marc buys 3 CDs. The substitution effect is 1 CD. To divide the price effect into a substitution effect and an income effect, take enough income away from Marc and gradually move his new budget line back toward the origin until it just touches Marc’s indifference curve I0. The point at which this budget line just touches indifference curve I0 is 2 CDs and 0.5 can of root beer. The substitution effect is the increase in the quantity of CDs from 1 CD to 2 CDs along the indifference curve I0. The substitution effect is 1 CD. The income effect is 1 CD. The income effect is the change in the quantity of CDs from the price effect minus the change from the substitution effect. The price effect is 2 CDs (3 CDs minus the initial 1 CD). The substitution effect is an increase in the quantity of CDs from 1 CD to 2 CDs. So the income effect is 1 CD. CDs are a normal good for Marc because the income effect is positive.

c.

d.

e.

3.

Marc buys 2 cans of root beer and 1 CD. Marc buys the quantities of root beer and CDs that moves him onto the highest indifference curve, given his income and the prices of root beer and CDs. The graph shows Marc’s indifference curves. So draw Marc’s budget line on the graph. The budget line is tangential to indifference curve I0 at 2 cans of root beer and 1 CD. The indifference curve I0 is the highest indifference curve that Marc can get attain.

Marc’s marginal rate of substitution is 2. The marginal rate of substitution is the magnitude of the slope of the indifference curve at Marc’s consumption point, which equals the magnitude of the slope of the budget line. The slope of Marc’s budget line is −2, so the marginal rate of substitution is 2.

a.

b.

c. d.

e.

Pete can still buy 20 cans of tuna and 40 golf balls. When Pete buys 20 cans of tuna at $2 a can and 40 golf balls at $1 each, he spends $80 a month. Now that the price of a can of tuna is $3 and the price of a golf ball is $0.50, 20 cans of tuna and 40 golf balls will cost $80. So Pete can still buy 20 cans of tuna and 40 golf balls.

Pete will not want to buy 20 cans of tuna and 40 golf balls because the marginal rate of substitution does not equal the relative price of the goods. Pete will move to a point on the highest indifference curve possible where the marginal rate of substitution equals the relative price.

Pete prefers tuna at $3 a can and golf balls at $0.50 each because he can get onto a higher indifference curve than when tuna is $2 a can and golf balls are $1 each.

Pete will buy more golf balls and fewer cans of tuna. The new budget line and the old budget line pass through the point at 20 cans of tuna and 40 golf balls. If cans of tuna are plotted on the x-axis, the marginal rate of substitution at this point on Pete’s indifference curve is equal to the relative price of a can of tuna at the original prices, which is 2. The new relative price of a can of tuna is $3/50 cents, which is 6. That is, the budget line is steeper than the indifference curve at 20 cans of tuna and 40 golf balls. Pete will buy more golf balls and fewer cans of tuna.

There will be a substitution effect and an income effect. A substitution effect arises when the relative price changes and the consumer moves along the same indifference curve to a new point .

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where the marginal rate of substitution equals the new relative price. An income effect arises when the consumer moves from one indifference curve to another, keeping the relative price constant.

4.

a.

b.

c.

Books are goods and so are taxed under both a sales tax and a consumption tax. Haircuts are services and so are taxed only under a consumption tax. If the sales tax is replaced with a consumption tax, the relative price of a haircut rises and the relative price of a book falls.

Assuming the sales tax and consumption tax are the same rate, in the figure the budget line rotates inward around a fixed book intercept. In Figure 9.2, the new budget line is BL1. The price of a book does not change but the price of a haircut rises.

In general, if the relative price of a haircut rises and the relative price of a book falls, the substitution effect leads consumers to buy more books and fewer haircuts. There is, however, also an income effect. The consumer’s real income falls, which decreases the demand for normal goods.

Assuming that both books and haircuts are normal goods, then the income effect offsets the substitution effect of buying more books but reinforces the substitution effect of buying fewer haircuts. In the figure, with the sales tax and budget line BL0 the consumer is initially at point A and buys 20 books per year and 4 haircuts per year. With the consumption tax and budget line BL1 the consumer moves to point B and buys 15 books per year and 3 haircuts per year.

Additional Discussion Questions 1.

2.

3.

How does an increase in the price of basic food staples affect real income in poor countries? Illustrate this with a budget line and hypothetical consumption bundle.

Where money incomes are low, increases in food prices can devastate real incomes and the achievable consumption bundle. The budget line, already close to the origin, shifts inward even closer. Food riots returned to the global stage in 2008, and with the prices of many key grains rising in 2010, we may see continued global dialogue about the negative impact of higher food prices on the world’s poorest citizens.

How would the preference map shift if a consumer had a strong preference for one of the products versus the other? How might that affect the tangency point? The map tilts to be “long” on the axis of the non-preferred product. Basically to get the person give up a unit of the preferred product, compensation in terms of units of the other product to maintain indifference would be immense. The tangency is thus likely to be near the axis of the preferred product, which means a large quantity of this good is consumed.

Will a low-income person’s optimal consumption bundle change if he or she receives food stamps? Have the students apply a normal preference mapping between food and all other goods for a low-income person. With food on the vertical axis, show that a person receiving food stamps experiences a new, steeper budget line with a higher y-intercept.

Show that the person can now afford a greater total amount of food for any given level of other goods, but the maximum amount of all other goods available remains unchanged. .

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Have the students locate the consumption combination that matches the slope of the new budget line with the marginal rate of substitution of the highest indifference curve.

Could the low-income person be better off with an income subsidy of equal value to the food stamp subsidy? Show that if the same level of income were given in place of food stamps, this opens up even more combinations of goods and services than with food stamps. It is impossible not find a higher indifference curve without a very unconventional indifference curve map.

Could a low-income person be made equally as well off with a lower total income subsidy than the initial food stamp subsidy? Ask them to consider why the government continues to use food stamps instead of income assistance when the same quantity of extra income would bring them even more utility. Ask them why the government doesn’t minimize total welfare assistance expenditures by giving them just enough income to maintain a consumption bundle on the same indifference curve as with the current food stamp expenditures. Students should recognize that part of the government’s intention is to control the type of items purchased with food stamps. If low-income households were simply given cash subsidies, the costs of the welfare system would be lower, but not all lowincome households would spend that cash subsidy on food only.

Would the indifference curves of a preference map ever change shape when the prices of goods change? Marketing managers for Ferrari claim that they would not consider a significant price decrease in the face of falling demand. They worry that the decrease in the perceived “exclusivity” of the brand would diminish the consumer perception of their product and eventually decrease market demand. Ask the students to model this theory and show how a sharp decline in the price of a Ferrari might causes a change in the consumer’s indifference curves. (The answer is that if Ferraris were placed on the vertical axis, the indifference curves are steeper.)

Would indifference curves ever move whenever the consumer’s income changes?

Consumers change their buying habits as they increase their income. They buy cars with leather seats instead of cloth, designer dresses and purses, choose restaurants merely to “be seen” dining there. Does this really represent a change in the preference mapping over consumption possibilities when incomes increase? Does it change the slope of the indifference curve?

Do perfect substitutes imply perfectly elastic demand? When indifference curves are straight lines, the MRS is almost never equal to the relative price ratio, meaning the consumer selects a “corner solution” (all of one good, or all of another, but not a mix of both). In the case of a relative price change, the consumer immediately switches to consuming only the other good. Ask the students if they have ever observed such peculiar consumer behavior in the real world.

Do perfect complements imply perfectly inelastic demand? When the indifference curves are 90-degree angles, the consumer always purchases the product only in exact proportions. Ask the students if there is any usefulness to separating out the two goods as separate items, or whether it is more meaningful to consider them two necessary components of a single good. For example, we rarely see single shoes being offered for sale, but surely the occasional consumer loses a single shoe, or there are a small number of amputees that need only one shoe. Why is there no market for single shoes? (As a counterexample, Lands’ End actually sells single gloves or mittens to consumers who have lost one of a pair.)

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ORGANIZING PRODUCTION

The Big Picture Where we have been: Chapter 10 introduces students to the firm as a decision making entity with an organizational structure and a specific goal. Key ideas in this chapter are recognizing the importance of having access to accurate cost and profitability information for making sound business decisions (learning the difference between economic versus accounting profit) and using the correct notion of efficiency as a criteria for making these decisions (understanding the difference between technological versus economic efficiency).

Where we are going: The chapter provides a clear overview to the key features of the market structures to be studied in the following chapters and will help students to be able to compare and contrast the features as each is introduced. Understanding the nature of the firm allows students to gain a better appreciation of those chapters, which cover business decisions made by the firm under different market structures. Chapter 11 introduces the firm’s production function and cost functions. Chapter 12 examines firm performance in a competitive environment, and Chapter 13 explores the firm as a monopoly. Chapters 13 and 14 look at firm behavior under monopolistic competition and oligopoly. Chapter 18 covers the firm’s decisions in the resource and labor markets.

New in the Thirteenth Edition The Economics in the News application in the chapter has been updated to consider principles and agents at Apple. The descriptions of the data in the application on market concentration in the U.S. economy has been updated. The end of chapter Economics in News analysis now discusses the expanding market for mobile advertising

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Lecture Notes

Organizing Production • • •

I.

Firms must organize their production so that it is as efficient as possible.

Firms operate in markets that differ according to the competition within the market.

Firms organize some economic activities while markets are used for other economic activity.

The Firm and Its Economic Problem •

The number and scope of business firms in the economy is vast and diverse. A firm is an institution that hires factors of production and organizes those factors to produce and sell goods and services.

The Firm’s Goal •

The firm’s goal is to maximize its profit. If a firm fails to maximize profit it is either eliminated through competition or bought out by other firms seeking to maximize profit.

Do firms really maximize profit? Sometimes firms state they are willing to bear lower profits to expand market share. Other firms claim to utilize only the “greenest” technology in their production process. Ask the students if these are long term goals or short term objectives for these firms. They should see that maximizing market share or using the latest green technology is an effort to gain greater market power and consumer loyalty in the long run, so that the firm can raise market prices and increase its profits.

Remember that the capital necessary to pursue green production methods can only be retained if the firms are able to match the alternative profitable uses for that capital, because the owners of that capital seek out the highest rate of return.

Accounting Profit and Economic Profit • •

A firm’s accounting profit is the firm’s revenues minus expenses and depreciation.

A firm’s economic profit is equal to total revenue minus total opportunity cost.

A Firm’s Opportunity Cost of Production • •

A firm’s decisions respond to opportunity cost and economic profit. A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production.

Opportunity costs of production include the cost of resources that are bought in the market, owned by the firm, or supplied by the firm’s owner.

• For example, renting capital means the firm is paying a rental cost reflecting the opportunity cost to the owner of the capital when someone else using the capital. However, if the firm buys capital it incurs an opportunity cost of using its own capital, which is called the implicit rental rate of capital. The implicit rental rate includes economic depreciation, which is the change in the market value of capital over a given period, and the interest forgone, which is the lost potential return on the funds that were used to acquire the capital.

• The return to the owner for the owner’s entrepreneurial ability is profit. The return for this input that an entrepreneur can expect to receive on the average is called normal profit. The normal profit is part of the firm’s opportunity cost. Economic profit is a firm’s total revenue minus its opportunity cost. Because normal profit is part of the firm’s opportunity costs, economic profit is profit over and above normal profit.

Is economic profit a “better” measure of profit than accounting profit? Economic profit and accounting profit really have different purposes, so one is not universally better or worse than the other.

Economic profit is a better measure of whether a firm is using its resources efficiently and is a better measure for predicting a firm’s actions, but accounting profit may be a better measure of whether the firm is earning enough revenue to pay its expenses. Emphasize the difference between accounting profit and economic profit when a firm owner is using cost information to make business decisions. Only economic .

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profit reflects the full opportunity cost of making a business decision and it is vital for assessing the true financial health of a firm. Stress that accountants are limited in their ability to interpret and report the costs of production: All accounting costs must either be documented with a receipt or estimated according to strict, generally accepted accounting procedures (GAAP). Point out the principal-agent problem that arises when firm managers can exploit the limitations of accounting profit calculations to under-report costs and over-report revenues to paint an artificially rosy financial picture for the firm—to the detriment of the firm owners.

Decisions •

In order to maximize economics profit, a firm must decide: • What to produce and in what quantities.

• How to produce.

• How to organize and compensate its managers and workers.

• How to market and price its products.

• What to produce itself and what to buy from others.

The Firm’s Constraints •

A firm faces three basic constraints that limit its maximum profit: • Technology Constraints: A technology is any method of producing a good or service. At the existing level of technology, a firm can produce more output only if it hires more resources, which increases its costs and limits its profits.

• Information Constraints: A firm has only limited information about the quality and effort of its work force, about the current and future buying plans of its customers, and about the plans of its competitors.

• Market Constraints: What a firm can sell and the prices it sets are constrained by its customers’ willingness to pay and by the prices and marketing efforts of other firms.

II. Technological and Economic Efficiency •

•

There typically are many different combinations of inputs that can produce a specific level of output. Technological efficiency occurs when a firm produces a given output by using the least amount of inputs. Economic efficiency occurs when the firm produces a given output at the least possible cost. An economically efficient production process is always technologically efficient. But, a technologically efficient process might not be economically efficient.

The table has 4 different methods of producing a unit of Method Labor Capital output. The columns show the number of units of labor 1 5 10 and capital needed to produce 1 unit of output.

• Method 2 is technologically inefficient because it uses 2 10 10 the same amount of capital but more labor than does 3 15 9 Method 1.

4 20 1 • Which method is economically efficient depends on the prices of labor and capital. If labor is $10 per unit and capital is $1, then Method 1 is economically efficient (with a cost of $60 per unit of output). If labor is $1 per unit and capital is $10 per unit, then Method 4 is economically efficient (with a cost of $30 per unit of output).

Does technological efficiency imply economic efficiency (or vice versa)? Point out that technological efficiency minimizes the quantity of resources used in producing a given level of output, while economic efficiency minimizes the value of the resources being used. Since all resources are not equally priced (let alone equally productive), there will inevitably be a difference between technological and economical efficiency. .

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III. Information and Organization A firm organizes production by combining and coordinating productive resources using a mixture of command systems and incentive systems.

• • •

A command system uses a managerial hierarchy. Commands pass downward through the hierarchy and information (feedback) passes upward.

An incentive system uses a market-like mechanism inside the firm.

The principal-agent problem is the problem of devising compensation rules that induce an agent to act in the best interests of a principal. For example, the stockholders of a firm are the principals and the managers of the firm are their agents. Stockholders wish to provide incentives to the managers to bring the manager’s decisions in line with profit maximization. Firms cope with the principal-agent problem in many ways: • Ownership: Firms’ owners often offer managers partial ownership of the firm to give the managers an incentive to maximize the firm’s profits, which is the goal of the owners.

• Incentive pay: Firms’ owners can links managers’ or workers’ pay to the firm’s performance, such as its sales, to help align the managers’ and workers’ interests with those of the owners.

• Long-term contracts: Firms’ owners can tie managers’ or workers’ long-term rewards to the long-term performance of the firm.

The Economics in the News considers principals and agents at Apple, and how top executives took a pay cut after the iPhone 6e failed to reach its revenue and profit targets. Because the case identifies both the questions and the solution, it would be useful to reinforce this example with another drawn from recent headlines.

Types of Business Organization •

• •

•

A proprietorship is a firm with a single owner. This owner has unlimited legal liability, which means the owner has legal responsibility for all debts incurred by the firm up to an amount equal to the entire wealth of the owner. The proprietor is the only one who makes management decisions and is the sole claimant of the firm’s profit. Profits are taxed the same as the owner’s other income.

A partnership is a firm with two or more owners. Each partner has unlimited legal liability. The partners must agree upon a management structure and agree how to divide up the profits from the firm. Profits from partnerships are taxed as the personal income of the owners.

A corporation is a firm that is owned by one or more stockholders with limited liability, which means the owners have legal liability only for the initial value of their investment, so the personal wealth of the stockholders is not at risk if the firm goes bankrupt. The profit of corporations is taxed twice—once as a corporate tax on the firm’s profits, and then again as income taxes paid by stockholders receiving their after-tax profits distributed as dividends.

Proprietorships are the most common form of business organization but corporations account for the majority of revenue received by all types of business organization.

Student businesses: Students generally have no idea how to legally form and operate a business.

Discussing a sole proprietorship example for a simple business is helpful and engages interest of some students. How they would legally start a business and report income so easily often reinforces the efficiency ideas we discuss elsewhere. The Economics in Action case summarizes the numbers for the various types of firms in the U.S. economy and table 10.4 nicely identifies the pros and cons of each form of organization.

IV. Markets and the Competitive Environment •

Perfect competition is a market structure when there are many firms, each selling an identical product, many buyers, and with no restrictions on entry of new firms to the industry. Both firms and buyers are well informed of the prices of the products of all firms in the industry. .

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Monopolistic competition is a market structure in which a large number of firms compete by making similar but slightly different products. Making a product slightly different from the product of a competitor is called product differentiation and it gives the firm an element of market power.

Oligopoly is a market structure in which a small number of firms compete. Oligopolies might produce almost identical or differentiated goods.

Monopoly arises when there is one firm, which produces a good or service that has no close substitutes and in which the firm is protected by a barrier preventing the entry of new firms.

Measures of Concentration There are two measures of market concentration: • •

The four-firm concentration ratio is the percentage of the value of sales accounted for by the four largest firms in the industry. The four-firm concentration ratio ranges between near 0 (extremely competitive) to 100 (not very competitive).

The Herfindahl–Hirschman Index (HHI) is the square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. The HHI ranges between near 0 (extremely competitive) to 10,000 (a monopoly).

An Economics in Action case identifies the HHI for various industries in the United States, with cigarettes and batteries being the most concentrated and quick printers and bakeries the least of those included. It also describes why other information may also be necessary to conclude how competitive a specific market is.

•

•

The U.S. Justice Department uses the HHI to classify markets: • Markets with an HHI of less than 1,000 are regarded as highly competitive.

• Markets with an HHI of between 1,000 and 1,800 are regarded as moderately competitive.

• Markets with an HHI above 1,800 are regarded as concentrated.

Concentration measures fail to take account of: • Geographic Scope of the Market: Concentration ratios define the market as the entire United States, but the relevant market might be smaller than the entire nation (newspapers, for which the market is a city) or larger than the entire nation (automobiles, for which the market is the entire world).

• Barriers to Entry and Firm Turnover: For some industries, a few firms might be currently operating in the market but competition in these industries might be fierce, with firms regularly entering and exiting the industry.

An Economics in Action application considers data from 1939 to 1980 that were used to study the degree of competition in U.S. markets. These data concluded there were more firms operating in competitive markets in 1980 than in 1939. Because the data do not capture the degree of global competition that has resulted after 1980, the study may understate the degree to which markets are competitive today.

•

Market and Industry Correspondence: Some firms produce a product with very specific applications for which few competitors exist, but are classified in too broad of a market (specific pharmaceutical drugs) while other firms have diversified into several distinct product lines and are subject to more effective competition than what their market share for just one product might suggest.

How do economists identify the market for a product? Examples: Geography: the (expanding) market for beer. In the early 20th century, a market for any given brand of beer was largely limited to the geographic area within a days’ truck drive from the brewery—if the beer traveled for too long under too high an ambient temperature, the trip ruined the product. When technological advances in mobile refrigeration made transporting beer over the road economical, local .

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monopoly brands suddenly felt the pain of competition from out-of-state brands that had never before been observed in the local market.

Demography: the (hidden) market for cigarettes. Can you define the market for a cigarette manufacturer by looking only at the market among adults? What if mostly illegal, under-aged smokers favored the brand rather than adult smokers? The sales to minors would not likely be recorded, yet it represents market share.

Substitutability: the (changing) market for personal transportation. Can you define the market for personal transportation? Twenty-five years ago it meant just the market for cars. Today, if we wanted to determine the market share for an auto manufacturer that happens to only sell cars, would the definition of the market for personal (as opposed to commercial) transportation include only cars? Or should trucks, mini-vans and SUVs be included as well? How about motorcycles and scooters?

The World Wide Web of business. Conclude the discussion of market definition by mentioning how today, items can be produced anywhere in the world and can be discovered and ordered from anywhere else in the world using the World Wide Web. These items can be paid for through electronic accounts located only in cyber-space, and the product can be shipped literally overnight to nearly any city in any developed country around the world. Stress how difficult it is to discern even the relevance of the term “market” in today’s business climate.

What is the relevant market for Ford Motor Company? Ford Motor Company advertises that it is the largest seller of pickup trucks in the United States. Should we be concerned that Ford might have too much market power in that area of the market? Ask the students to consider identifying what would be an appropriate definition for the “market” such that a proper market concentration measure might be calculated. Should only pickup trucks be included? Or should all cars and trucks be considered as possible substitutes? How about minivans and/or SUVs?

V. Produce or Outsource? Firms and Markets • • • •

Factors of production can be coordinated by firms or by markets.

Firms coordinate production when they can do so more efficiently than a market.

Markets coordinate production by adjusting prices and making the decisions of buyers and sellers of factors of production consistent.

Outsourcing, buying parts or products from other firms, is an example of market coordination.

Why might firms be more efficient at coordinating production than markets?

• • • • •

Firms can reduce transactions costs, which are the costs that arise from finding someone with whom to do business, of reaching an agreement about the price and other aspects of the exchange, and of ensuring that the terms of the agreement are fulfilled.

Firms can capture economies of scale, which occurs when the cost of producing a unit of a good falls as its output rate increases.

Firms can capture economies of scope, which occurs when a firm can use specialized inputs to produce a range of different goods at a lower cost than otherwise.

Firms can engage in team production, in which the individuals can coordinate to specialize in mutually supporting tasks.

Because of these advantages, firms rather than markets coordinate most of our economic activity.

Economics in Action: Apple doesn’t produce the iPhone by itself. Global supply chains, high degrees of specialization and competition, and other innovations have made it possible for a company to design and market a product, collect most of the profit from it, and yet not produce it.

Why do firms exist? Ronald Coase is the classic on this topic. You might like to tell your students about this remarkable person. Born in England in 1910, he graduated with a bachelor of commerce degree in .

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1932, at the depth of the Great Depression. While still an undergraduate, he was puzzled by the fact that he was being taught that markets coordinate economic activity, yet all around him he could see firms that were also coordinating economic activity. “Why?” he wondered. The question was especially important at that time because Socialists (and the young Coase was one of them) thought that central planning by government was superior to the market.

Quoting from Coase’s autobiography, http://www.nobel.se/economics/laureates/1991/coaseautobio.html, “I spent the academic year 1931-32 on my Cassel Travelling Scholarship in the United States studying the structure of American industries, with the aim of discovering why industries were organized in different ways. I carried out this project mainly by visiting factories and businesses. What came out of my enquiries was not a complete theory answering the questions with which I started but the introduction of a new concept into economic analysis, transaction costs, and an explanation of why there are firms. All this was achieved by the Summer of 1932, as the contents of a lecture delivered in Dundee in October 1932, make clear. These ideas became the basis for my article “The Nature of the Firm,” published in 1937, cited by the Royal Swedish Academy of Sciences in awarding me the 1991 Alfred Nobel Memorial Prize in Economic Sciences.”

So, this amazing scholar had done his Nobel-prize-winning work at the age of 22!

An Economics in the News article discusses the growth of mobile advertising and how Facebook and Google are both dominant in advertising with smartphones.

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Additional Problems 1.

Sue can do her accounting assignment by using: a personal computer; a pocket calculator; a pocket calculator and a pencil and paper; or a pencil and paper. With a PC, Sue completes the job in half an hour; with a pocket calculator, it takes 4 hours; with a pocket calculator and with a pencil and paper, it takes 5 hours; and with a pencil and paper, it takes 14 hours.

The PC and its software cost $2,000, the pocket calculator costs $15, and the pencil and paper cost $3. a. Which, if any, of the methods is technologically efficient? b. Which methods is economically efficient if Sue’s wage rate is (i) $10 an hour? (ii) $20 an hour? (iii) $50 an hour?

2.

Alternative ways of making 100 shirts a day are in Method Labor Capital the table to the right. (hours) (machines) a. Which methods are technologically efficient?

A 10 50 b. Which method is economically efficient if: B 20 40 (i) The wage rate is $1 an hour and the rental cost of C 50 20 a machine is $100 an hour?

D 100 10 (ii) The wage rate is $5 an hour and the rental cost of a machine is $50 an hour? (iii) The wage rate is $50 an hour and the rental cost of a machine is $5 an hour?

3.

Sales of the firms in the pet food industry are in the table to the right. a. Calculate the four-firm concentration ratio. b. What is the structure of the industry?

4.

Market shares of mat makers are in the table to the right. a. Calculate the Herfindahl-Hirschman Index. b. What is the structure of the industry?

.

Firm Big Collar, Inc Shiny Coat, Inc Friendly Pet, Inc Naturals Way, Inc Other 8 firms

Firm Made-to-last, Inc Big Wheel, Inc Magic Carpet, Inc Supreme, Inc Copra, Inc

Sales (thousands of dollars) 50 75 60 65 400

Market share (percent) 20 17 22 17 24

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Solutions to Additional Problems 1.

a.

b.

2.

a.

b.

3.

a.

b.

4.

a.

b.

All methods other than “pocket calculator with paper and pencil” are technologically efficient. To use a pocket calculator with paper and pencil to complete the accounting assignment is not a technologically efficient method because it takes more hours than it would with a pocket calculator and it uses more capital.

The economically efficient method is the technologically efficient method that allows the task to be done at least cost. (i) When the wage rate is $10 an hour: Total cost with a PC is $2,005, total cost with a pocket calculator is $55, and total cost with paper and pencil is $143. Total cost is least with a pocket calculator. (ii) When the wage rate is $20 an hour: Total cost with a PC is $2,010, total cost with a pocket calculator is $95, and the total cost with paper and pencil is $283. Total cost is least with a pocket calculator. (iii) When the wage rate is $50 an hour: Total cost with a PC is $2,025, total cost with a pocket calculator is $215, and total cost with pencil and paper is $703. Total cost is least with a pocket calculator.

Methods A, B, C, and D are technologically efficient. Compare the amount of labor and capital used by the four methods. Start with method A. Moving from A to B to C to D, the amount of labor increases and the amount of capital decreases in each case.

The economically efficient method in (i) is method D, in (ii) is method D, and in (iii) is method A. The economically efficient method is the technologically efficient method that allows the 100 shirts to be made at least cost. (i) Total cost with method A is $5,010, total cost with method B is $4,020, total cost with method C is $2,050, and total cost with method D is $1,100. Method D has the lowest total cost. (ii) Total cost with method A is $2,550, total cost with method B is $2,100, total cost with method C is $1,250, and total cost with method D is $1,000. Method D has the lowest total cost. (iii) Total cost with method A is $750, total cost with method B is $1,200, total cost with method C is $2,600, and total cost with method D is $5,050. Method A has the lowest total cost.

The four-firm concentration ratio is 38.46. The four-firm concentration ratio equals the ratio of the total sales of the largest four firms to the total industry sales expressed as a percentage. The total sales of the largest four firms is $50,000 + $75,000 + $60,000 + $65,000, which equals $250,000.

Total industry sales equal $250,000 + $400,000, which equals $650,000. The four-firm concentration ratio equals ($250,000/$650,000) 100, which is 38.46 percent.

This industry is competitive because the four-firm concentration ratio is less than 60 percent.

The Herfindahl-Hirschman Index is 2,038. The Herfindahl-Hirschman Index equals the sum of the squares of the market shares of the 50 largest firms or of all firms if there are less than 50 firms.

2 2 2 2 2 The Herfindahl-Hirschman Index equals 20 + 17 + 22 + 17 + 24 , which equals 2,038.

This industry is not competitive because the Herfindahl-Hirschman Index exceeds 1,800.

Additional Discussion Questions 1.

What decisions go into setting up and operating your own business? Have the students imagine starting up their own firm after graduation. Let them dream about pursuing their passion and trying to make a living at it, and get them to appreciate the complexities of organizing production and making a profit. Challenge them with the following business .

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decision issues and open their eyes to how much risk must be endured and how much market perceptiveness is necessary to be a successful entrepreneur.

Organizing your firm. Ask students if the initial capital requirements for their dream business would be extensive, such as starting up a high-performance car manufacturing firm (John DeLorean tried this, but his attempt to raise financial capital caused him to take a bit of a career detour—he was tried, and acquitted, for trafficking drugs!), or merely a modest capital outlay. Will the size and scope of their operation require a large management structure with a diversity of specialized managers, or a small, streamlined structure with only a few managers in multi-purpose roles? Will they want to spread out the risk of financial liability among stockholders in exchange for sharing a portion of their profit?

Determining your firm’s financial reporting standards. What financial reporting standards will their firm practice? Ask the students how they will treat the wages paid to themselves, the owners of the firm? Mention that if their best alternative job has just experienced a significant increase in salary, the implicit cost of running their own business has just increased and their economic profitability has decreased. Point out that if they were to give themselves a raise to reflect the higher opportunity cost and transform that implicit cost into an explicit cost, their accounting profit then declines as well. Not only will a lower profit report for the period hurt their firm’s perceived stature in the industry, it will also make it more costly for their firm to raise financial capital in the future.

Determining appropriate sources of information. Where will they receive the information needed to locate good workers and managers? Where can they find the market wages, salaries, and benefits that they must offer to their employees in order to attract quality people to work with them instead of other firms? How will they uncover all the business regulations, licensing, periodic tax filing procedures, and labor laws that must be strictly followed to remain in operation?

2.

How do corporate taxes affect efficiency? Ask the students to recall the deadweight loss of taxation analyzed in Chapter 6 and apply it to the double taxation of corporate profits. Help them to see that they can model the effects of the compounding deadweight losses by using the production possibilities frontier. Show them how the corporate tax causes movement of the economy to production combinations that are inefficient and in the interior of the production possibilities frontier.

3.

Should you hire a contractor or a development company to build your house? Mention to the students that if a market is more efficient at allocating resources among buyers and sellers than a firm, the market will be characterized by the presence of many different contractors or consultants, rather than with traditional companies. Ask the students to identify some of these kinds of markets and get them to consider what characteristics of the products or services do not lend themselves to the organizational structure of the firm. For example, ask the students what characteristics that describe the building of new residential homes that encourages a predominance of contractors rather than firms to supply new residential housing? In this market, independent, general construction contractors who deal with many sub-contractors are the entities that tend to build individual “spec” homes. Yet, in the same market there are also a few large residential developments of “cookie cutter” homes built in a small geographic area by one firm. Perhaps the high cost of monitoring the progress in many off-site work areas, combined with a high degree of variation in the customer preferences for the product, prevents any economies of scale to be enjoyed by a firm trying to build “spec” homes. Perhaps the economies of scale can only be enjoyed in a small geographic area with a high concentration of construction sites managed by one firm. .

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4.

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Compare and contrast the possible result of Apple outsourcing the iPad’s production with doing it all within the firm. Competition among component makers likely leads to lower costs and a greater speed of innovation in terms of product features. Technology transfer will be more widespread as firms try to mimic what others are producing and as firms that develop new technologies are likely to be able to sell some or all of those features to other firms or markets (such as programmable chips migrating from devices to autos to green energy grids). Under the outsourcing system, Apple is more vulnerable to problems with a supplier delaying products or damaging the firm’s reputation.

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11

OUTPUT AND COSTS

The Big Picture Where we have been: This chapter has explained how the firm’s output decision affects its costs when the firm allocates its factors of production efficiently in the short run and in the long run. The student sees how establishing short-run productivity and cost measures and understanding how they are related reveals how a firm can predict how its costs will change with the level of output. This relationship helps firm managers make profitable output decisions in the short run and make commitments to efficient plant size in the long run.

Where we are going: Chapters 12, 13, 14, and 15 use the productivity and cost relationships developed in this chapter to explain how firms make decisions in competition, monopoly, and other market structures. Chapter 18 uses these same ideas to explain how firms decide how much labor and capital to use.

New in the Thirteenth Edition Some of the examples and applications have been updated. The introduction connects to a new Economics in the News case that discusses Ikea’s decision to open a new store in Nashville, TN. The example using costs of check out stations at retail stores now is prefaced with Target’s decision to spend millions to remodel stores.

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Lecture Notes

Output and Costs • • •

I.

In the short run, a firm needs to increase the quantity of labor employed in order to increase its production.

In the long run, a firm can increase the quantity of any or all of the factors of production it employs to increase its production.

Firms must pay for the factors they use, so when a firm changes its production, its costs change.

Decision Time Frames •

A firm owner’s decisions can be categorized as short run decisions and long run decisions.

• The short run is a time frame in which the quantities of some factors of production are fixed.

The fixed factors include the firm’s management organization structure, level of technology, buildings and large equipment. These factors are called the firm’s plant.

• The long run is a time frame in which the quantities of all factors of production can be varied.

Long-run decisions are not easily reversed so usually a firm must live with the plant size that it has created for some time. The past cost of buying a plant that has no resale value is called a sunk cost.

Help the students to understand that the difference between the long run and short run is not related to calendar time. Compare the street vendor, who is a firm owner operating out of a food truck, to the giant automaker firm, Honda. Ask them how long it would take for the food vendor to double the size of his or her plant (truck, oven, etc.) versus Honda to double its plant size (factory buildings covering multiple blocks, computerized assembly lines and robotics, etc.). They will realize that the length of time covered by the long run differs among firms.

II. Short-Run Technology Constraint To increase its output in the short run, a firm must increase the quantity of labor employed. There are three relationships between the quantity of labor and the firm’s output.

Product Schedules •

Total product is the maximum output that a given quantity of labor can produce. The marginal product of labor is the increase in total product that results from a one-unit increase in the quantity of labor employed with all other inputs remaining the same. The average product of labor is equal to the total product of labor divided by the quantity of labor. The table to the right has examples of these product schedules.

Labor 0

Total product 0

1

10

Marginal product

Average product

10 10 20 2

30

15 6

3

36

12

Product Curves • •

The total product curve illustrates the total product schedule. The slope of the total product curve equals the marginal product of labor at that quantity of labor.

The marginal product curve shows the additional output generated by each additional unit of labor.

The marginal product of labor curve (MP) has an upside-down U shape. Increasing marginal returns occurs when the marginal product of an additional worker is greater than the marginal product of the previous worker. At low levels of employment, increasing marginal returns is likely because hiring an additional worker allows large gains from specialization. Eventually these gains become small or nonexistent and diminishing marginal returns set in. Diminishing marginal returns occur when the marginal product of an additional worker is less than the marginal product of the previous worker. The law of diminishing returns states that as a firm uses more of .

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•

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a variable factor of production, with a given quantity of the fixed factor of production, the marginal product of the variable factor eventually diminishes.

The average product curve shows the average product that is generated by labor at each level of labor. As the figure shows, the average product of labor curve (AP) has an upside-down U shape.

As the figure shows, the marginal product curve and the average product curve are related: when the marginal product of labor exceeds the average product of labor, the average product of labor increases; when the marginal product of labor is less than the average product of labor, the average product of labor decreases; and the marginal product of labor equals the average product of labor when the average product of labor is at its maximum.

The marginal pulls (but cannot not push) the average. Don’t let the students fall into the trap of thinking that if the marginal measure rises (falls) with the level of an activity, then the average measure must also rise (fall). This is a sloppy statement of the relationship between marginal and average measures. Use the tried-and-true grade point average (GPA) example used in the text. Explain that if a student’s GPA is a 3.5 and the next marginal class grade is a C (2.0), followed by a B (3.0), this increasing marginal grade will not be pushing their GPA up at all. Conceptually, the students should understand that the marginal value can’t “push” the average measure higher when it is, itself, lower than the average measure. The marginal measure must be higher (lower) than the average value if the average value is to rise (fall) with the level of activity, thereby “pulling” the average up (down).

Understanding marginal returns: Ask students to picture a typical fast food restaurant. This is a “plant” and equipment with which they are familiar as customers if not also as workers. Fixed inputs include the building and the equipment. Ask them to imagine one worker trying to cook the food, take the orders and run the drive through. Add a second worker and specialization can begin to occur, so the MP initially rises.

But keep adding workers and marginal product will inevitably fall. Diminishing returns is not the same as negative returns; students might need help understanding that total product is still rising, but at a decreasing rate.

III. Short-Run Cost

Labo r 0

Outpu t 0

Fixed cost (dollar s) 50

Variable cost (dollars)

Total cost (dollars)

0

50

Average fixed cost (dollars)

Average variable cost (dollars)

Average total cost (dollars)

1

10

50

100

150

5.00

10.00

15.00

2

30

50

200

250

1.66

6.67

8.33

3

36

50

300

350

1.39

8.33

9.72

Marginal cost (dollars) 10.00 5.00 16.67

The table above continues the previous product schedule table and shows different costs. .

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Total Cost •

Total cost (TC) is the cost of all the factors of production a firm uses. Total fixed cost (TFC) is the cost of the firm’s fixed factors. Total variable cost (TVC) is the cost of the firm’s variable factors.

Total cost is the sum of total fixed cost plus total variable cost so TC = TFC + TVC.

Relation between TP and TVC. Make a graph of a TP curve on a transparency. Label the x-axis labor and the y-axis output. Put some actual numbers on the labor axis (use 1, 2, 3, 4, and 5 labor units) and tell the students that the price of a unit of labor $10. Next, change the label on the x-axis to TVC and ask the students to tell you the numbers to put on the x-axis now that it measures TVC (the numbers will now be $10, $20, $30, $40 and $50). Once the students are really clear about what you have done, pick up the transparency, turn it over, and replace it on the display base with what was previously the x-axis (TVC) running vertically. Point out that the students are now looking at a TVC curve. Emphasize that all the product curves can be derived from the TP curve and all the cost curves can be derived from the TVC curve.

Marginal Cost •

Marginal cost (MC) is the increase in total cost that results from a one-unit increase in output. The MC curve is U-shaped. Initially greater specialization makes additional units cost less than those that have come before, but eventually diminishing returns sets in and marginal costs rise.

Average Cost • • •

Average fixed cost (AFC) is total fixed cost per unit of output. The value of AFC falls as output increases.

Average variable cost (AVC) is total variable costs per unit of output. At low levels of output, AVC falls as output increases but at higher levels of output, AVC rises as output increases.

Average total cost (ATC) is the total cost per unit of output. ATC = AFC + AVC. At low levels of output, ATC falls as output increases but at higher levels of output, ATC rises as output increases.

Marginal Cost and Average Cost •

The figure illustrates typical MC, AFC, AVC, and ATC curves. As the figure shows, the MC curve, the AVC curve, and the ATC curve are all U-shaped. There are other additional important points about this figure: • The vertical distance between the AVC curve and the ATC curve is the AFC. Because the AFC decreases as output increases, these curves become vertically closer to each other as output increases.

• The MC curve intersects the AVC curve and ATC curve at their minimums

Why the Average Total Cost Curve is U-shaped •

The ATC curve combines the shapes of the AFC and AVC curves. The AFC curve constantly falls as output expands, pulling down ATC curve. The AVC curve first falls but then rises because of diminishing returns. Eventually AVC curve starts to rise more rapidly than the AFC falls, so at that point the ATC rises.

An Economics in the News case describes a new cost curve application inspired by Target’s decision to spend millions to remodel its stores. The case derives and analyzes the cost curves for both traditional clerks and for checkout assistants for shoppers using self scan technologies.

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Cost Curves and Product Curves • •

The shape of the AVC curve is determined by the shape of the AP curve. Over the range of output for which the AP curve is rising, the AVC curve is falling and over the range of output for which the AP curve is falling, the AVC curve is rising.

The shape of the MC curve is determined by the shape of the MP curve. Over the range of output for which the MP curve is rising, the MC curve is falling and over the range of output for which the MP curve is falling, the MC curve is rising.

Making Decisions Using the Relationships Between Productivity and Cost. Explain to the students the usefulness of understanding the intuition behind the relationship between productivity measures and cost measures. For example: If a firm manager knows that average productivity of labor has been falling with the last additional quantity of labor hired, then the manager knows that the average variable cost (AVC) of production has necessarily been rising as the output from that additional labor has increased.

If the manager knows that AVC is rising as output increases, then the manager also knows that the marginal cost (MC) of the additional output has been higher than the AVC (which has been pulling AVC up).

If the manager has sold the previous units of output at a small profit, the manager might be faced with a time-sensitive contractual opportunity that arises within the same short run time period. The manager might be asked to sell a little more output at the same market price as the previous sales. The manager can quickly infer that the profitability of this potential new contract will not be as high because the marginal cost of producing the extra output will be higher than the last units of output produced. The manager can infer this result through productivity-cost relationships rather than knowing marginal costs directly.

Firm managers must frequently make quick decisions with little information. If managers have knowledge of a useful relationship between input measures (which are relatively easy to get) and production cost measures (which are more difficult to get—especially marginal cost figures) they can use their understanding of this link to make inferences about how production costs might behave when the firm’s output must change to accommodate market changes.

Shifts in the Cost Curves •

•

The cost curves shift with changes in technology or changes in prices of factors of production.

• An increase in technology that allows more output to be produced from the same resources shifts the cost curves downward. If the technology requires more capital, a fixed input, then the average total cost curve shifts upward at low levels of output and downward at higher levels of output.

A fall in the price of the fixed factor shifts the AFC and ATC curves downward but leaves the AVC and MC curves unchanged. A fall in the price of a variable factor shifts the AVC, ATC, and MC curves downward but leaves the AFC curve unchanged.

IV. Long-Run Cost In the long run, a firm can vary the level of all resources so both labor and capital are variable factors. As a result, in the long run all costs are variable costs.

The Production Function

The production function determines the behavior of long run costs.

• A firm’s production function typically exhibits diminishing returns to capital as well as diminishing returns to labor. The marginal product of capital is the change in total product divided by the change in capital when the quantity of labor is held constant. Holding constant the quantity of employment, after some level of output the firm will have diminishing returns to capital—the marginal product of capital decreases as more capital is used. .

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Short-Run Cost and Long-Run Cost •

•

In the long run, a firm can use different plant sizes. Each plant size has a different short-run ATC curve. Each short-run ATC curve is U-shaped and the larger the plant size, the greater is the output at which the average total cost is a minimum.

The figure illustrates three average total cost curves for three plant sizes. ATC1 pertains to the smallest plant size and ATC3 to the largest.

The Long-Run Average Cost Curve •

•

The long-run average cost curve, LRAC, is the relationship between the lowest attainable average total cost and output when both the plant size and labor are varied. This curve is derived from the short-run average total cost curves. It shows the lowest average total cost to produce a given level of output. In the figure, the LRAC curve is the darkened parts of the three short-run ATC curves.

The LRAC curve is a planning curve. Once the firm chooses a plant size, then it operates on the short-run costs curves associated with that plant size.

An Economics in Action case describes why a firm in the auto industry might have capital equipment that is not fully used. The firm is producing at a point on its short-run average total cost curve that is not the minimum of the short-run average cost curve, so the firm has under-utilized capital. But the production point is on the long-run average cost, so the quantity being manufactured is produced at the minimum average total cost.

Economies and Diseconomies of Scale •

•

•

•

Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output exceeds the percentage increase in all factors of production. The long-run average cost curve slopes downward in this range of output. The main source of economies of scale is greater specialization of both labor and capital.

Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output equals the percentage increase in all factors of production. The long run average cost curve is horizontal in this range of output.

Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. With given factor prices, economies of scale occur if the percentage increase in output is less than the percentage increase in all factors of production. The long run average cost curve slopes upward in this range of output.

The minimum efficient scale is the smallest quantity of output at which the long-run average cost curve reaches its lowest level.

Concepts are important, not just the formulas. Make good use of the glossary of productivity and cost terms provided in Table 11.2 in the text, but don’t get mired down in reciting productivity and cost measure definitions! Students must learn the definitions, but they are secondary to the concepts they define and the insights they bring. Stand back from the details of this chapter and be sure that your students learn two big ideas.

• A firm’s lowest production costs depend on the manager’s flexibility to choose the level of all factors.

This flexibility enables firm managers to produce at a lower cost in the long run than in the short run when some factors are fixed.

• In the short run, with one or more fixed factors, production costs vary with output in a predictable way because they are directly linked to measures of factor productivity.

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When does the firm actually reach the “long run”? Think of the long run as a window of opportunity in which firms get to re-make decisions. If things are going well, firms may be re-making decisions regularly and extending fixed inputs on a regular basis. But if things are going poorly, the window in which a lease can be broken or a contract not renewed will be pressing. Point out to the students that the long-run average cost curve yields the lowest average cost of production possible when plant size is free to change.

Once a firm commits to a specific plant size, it is locked into a specific short run cost curve configuration.

Any significant departure from the range of output per period that best suits that configuration means the firm will incur higher short-run average total costs than it would have had it chosen a more appropriate plant size. If faulty market analysis or unexpected changes in market conditions cause a firm to commit to a plant that is too small (or too large) when the required range of production is actually relatively high (or relatively low), then the firm will suddenly be locked into a much less competitive production cost situation with potentially dire economic consequences. If the firm’s competitors chose their plant size more wisely, the firm might have a tough time surviving! Who is successful in the long run may depend on decisions to get bigger or smaller that wound up being correct as market conditions changed.

Experiment: Learn about production by producing. This chapter is one more place where an in-class experiment has a huge payoff in student comprehension. This 30 minute experiment teaches students about product curves and production cost measures. It motivates the students to go beyond memorizing the cost and productivity definitions by getting them directly involved with generating their own data as well as productivity and cost measures. This fun exercise will illustrate the concept of diminishing returns to labor as well as how short-run productivity measures and production cost measures are related.

• Factors: Capital: A medium-sized table (the class must have an unobstructed view of it), tear-off scratch pads with about 500 sheets of paper, a fully loaded stapler, and a back-up stapler (also fully loaded). Labor: Provided by your students.

• The Task: To produce “widgets.” A widget is a piece of paper, torn from a pad, folded twice very carefully so that the corners of the paper align, and stapled. (The first fold bisects the paper along its long side and the second fold is at right angles to the first.) Once folded, it is stapled to hold the folds in place. A widget is fragile and breaks if it falls off the table.

• The Pre-Experiment Stage: Hire a manager from your class and appoint an auditor. Get the manager to hire a quality controller, an accountant, and some workers. Tell the manager that he must produce widgets as efficiently as possible and that he can discuss the process with his workers and with the class.

• The Experiment: A “work day” lasts for 1 minute. Get the class to keep time. On day 1, have one worker produce widgets. On day 2, have two workers produce widgets, and so on. You’ll probably run for 10 to 12 days before you get to almost zero marginal product. Record the inputs and outputs. Have some fun with quality control, shirking, and cheating. The auditor must ensure that old widgets and partly made widgets don’t get used in a subsequent day. Each day must start clean.

• The Assignment (Stage 1): Have the students to calculate marginal product and average product from the total product numbers that you’re recorded. Get them to make graphs of the total product, marginal product, and average product curves. Get them to describe the curves and to explain their similarities with and differences to the curves for sweater production in the textbook.

• The Assignment (Stage 2). Use the data from your widget production experiment and give the students figures for the cost of the capital and the wage rate of a worker. (Make up the numbers—any will do.) Tell the students to calculate total cost, marginal cost, and average cost. Get them to make graphs of the total cost, marginal cost, and average cost curves. Get them to describe the curves and to explain their similarities with and differences to the curves for sweaters in the textbook. (This assignment and the previous one make an outstanding assignment for credit.)

• The Experiment Extended. If you have the time, duplicate the capital of the first experiment and repeat all its steps. You should generate a horizontal LRAC. Get the class to think about what would have to happen in the context of this experiment to get economies of scale and diseconomies of scale. .

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Economics in the News discusses Ikea’s decision to open a new store in Nashville, TN.

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Additional Problems 1.

Charlie’s Chocolates total product schedule is in the table. a. Draw the total product curve. b. Calculate the average product of labor and draw the average product curve. c. Calculate the marginal product of labor and draw the marginal product curve. d. What is the relationship between the average product and marginal product when Charlie’s Chocolates produces (i) less than 276 boxes a day and (ii) more than 276 boxes a day?

2.

In problem 1, the price of labor is $50 per day, and total fixed costs are $50 per day. a. Calculate total cost, total variable cost, and total fixed costs for each level of output and draw the short-run total cost curves. b. Calculate average total cost, average fixed cost, average variable cost, and marginal cost at each level of output and draw the short-run average and marginal cost curves.

3.

Labor (workers per day) 1 2 3 4 5 6 7 8 9 10

Output (boxes per day) 12 24 48 84 121 192 240 276 300 312

In problem 2, suppose that the price of labor increases to $70 per day. Explain what changes occur to the short-run average and marginal cost curves?

4.

In problem 2, Charlie’s Chocolates buys a second plant and now the total product of each quantity of labor doubles. The total fixed cost of operating each plant is $50 a day. The wage rate is $50 a day. a. Set out the average total cost curve when Charlie’s operates two plants. b. Draw the long-run average cost curve. c. Over what output range is it efficient to operate one plant and two plants?

5.

The table shows the Labor Output production function (workers (pizzas per day) of Mario’s Pizza-toper day) Plant 1 Plant 2 Plant 3 Plant 4 Go. Mario must pay 1 4 8 11 13 $100 a day for each 2 8 12 15 17 oven he rents and $75 3 11 15 18 20 a day for each kitchen 4 13 17 20 22 hand he hires Ovens 1 2 3 4 a. Find and graph the average total cost curve for each plant size. b. Draw Mario’s long-run average cost curve. c. Over what output range does Mario experience economies of scale? d. Explain how Mario uses his long-run average cost curve to decide how many ovens to rent. .

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Solutions to Additional Problems 1.

a. b.

c.

d.

2.

a.

b.

3.

To draw the total product curve measure labor on the x-axis and output on the y-axis. The total product curve is upward sloping.

The average product of labor is equal to total product divided by the quantity of labor employed.

For example, when 3 workers are employed, they produce 48 boxes a day, so average product is 16 boxes per worker. The average product curve is upward sloping when the number of workers is between 1 and 8, but it becomes downward sloping when 9 and 10 workers are employed.

The marginal product of labor is equal to the increase in total product when an additional worker is employed. For example, when 3 workers are employed, total product is 48 boxes a day. When a fourth worker is employed, total product increases to 84 boxes a day. The marginal product of going from 3 to 4 workers is 36 boxes. The marginal product curve is upward sloping when the number of workers is between 1 and 6, but it becomes downward sloping when 7 or more workers are employed. (i) When Charlie’s Chocolates produces fewer than 276 boxes a day, it employs fewer than 8 workers a day. With fewer than 8 workers a day, marginal product exceeds average product and average product is increasing. Up to an output of 276 boxes a day, each additional worker adds more to output than the average. Average product increases. (ii) When Charlie’s Chocolates produces more than 276 boxes a day, it employs more than 8 workers a day. With more than 8 workers a day, average product exceeds marginal product and average product is decreasing. For outputs greater than 276 boxes a day, each additional worker adds less to output than average. Average product decreases.

Total cost is the sum of the costs of all the inputs that Charlie’s Chocolates uses in production. Total variable cost is the total cost of the variable inputs. Total fixed cost is the total cost of the fixed inputs.

For example, the total variable cost of producing 48 boxes a day is the total cost of the workers employed, which is 3 workers at $50 a day, which equals $150. Total fixed cost is $50, so the total cost of producing 48 boxes a day is $200.

To draw the short-run total cost curves, plot output on the x-axis and the total cost on the y-axis.

The total fixed cost curve is a horizontal line at $50. The total variable cost curve and the total cost curve have shapes similar to those in Fig. 11.4, but the vertical distance between the total variable cost curve and the total cost curve is $50.

Average fixed cost is total fixed cost per unit of output. Average variable cost is total variable cost per unit of output. Average total cost is the total cost per unit of output.

For example, when the firm makes 48 boxes a day: Total fixed cost is $50, so average fixed cost is $1.04 per box; total variable cost is $150, so average variable cost is $3.13 per box; and total cost is $200, so average total cost is $4.17 per box.

Marginal cost is the increase in total cost divided by the increase in output. For example, when output increases from 24 to 48 boxes a day, total cost increases from $150 to $200, an increase of $50. That is, the increase in output of 24 boxes increases total cost by $50. Marginal cost is equal to $50 divided by 24 boxes, which is $2.08 a box.

The short-run average and marginal cost curves are similar to those in Fig. 11.5.

The increase in the price of labor increases total variable cost and total cost but does not change total fixed cost. Average variable cost is total variable cost per unit of output. The average variable cost curve shifts upward. Average total cost is total cost per unit of output. The average total cost curve shifts upward. The marginal cost curve shifts upward. Average fixed cost does not change.

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b.

c.

5.

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b. c.

d.

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Total cost is the cost of all the factors of production. For example, when 3 workers are employed they now produce 96 boxes a day. With 3 workers, the total variable cost is $150 a day and the total fixed cost is $100 a day. The total cost is $250 a day. The average total cost of producing 96 boxes is $2.60.

The long-run average cost curve is made up of the lowest parts of the firm’s short-run average total cost curves when the firm operates one plant and two plants. The long-run average cost curve is similar to Fig. 11.8.

It is efficient to operate the number of plants that has the lower average total cost of a box of chocolates. It is efficient to operate one plant when output is less than 48 boxes a day, and it is efficient to operate two plants when the output is more than 48 boxes a day. Over the output range 1 to 48 boxes a week, average total cost is less with one plant than with two, but if output exceeds 48 boxes a day, average total cost is less with two plants than with one.

For example, the average total cost of producing a pizza when Mario rents 2 ovens and employs 4 workers equals the total cost ($200 rent for the ovens plus $300 for the workers) divided by the 17 pizzas produced. The average total cost equals $500÷17, which is $29.41 a pizza. The average total cost curve is U-shaped, as in Fig. 11.5.

The long-run average cost curve is similar to that in Fig. 11.8.

Mario experiences economies of scale at output levels of 4 to 15 pizzas a day. When economies of scale are present, the LRAC curve slopes downward. Mario’s LRAC curve slopes downward between the output levels of 4 to 15 pizzas a day.

Mario will choose the plant (number of ovens to rent) that gives him minimum average total cost for the normal or average number of pizzas that people buy.

Additional Discussion Questions 11. Is the law of diminishing returns a result of firms hiring the best workers first? Students should understand that diminishing returns to labor occur under the assumption of a homogenous work force. Emphasize that diminishing marginal returns occur due to labor’s decreasing productivity given a fixed level of capital. The law of diminishing returns is defined in the short run only. As the amount of capital increases, as technology changes, or as the size of the plant increases, labor productivity can increase. If the variable input was a herbicide or a fertilizer on a farm field, diminishing returns would still be observed.

2.

Do increasing marginal costs result from the rising wages of workers? Students should understand that rising marginal cost in the short run results from diminishing marginal productivity of labor holding the wages for labor constant. Show the students the following thought process: • Employing another labor unit increases output, but the extra output is less than the added output from the previous labor unit (diminishing marginal productivity).

• Each labor unit costs the same to employ, so the firm is getting less additional output for the same additional cost (constant cost of labor).

• As a result, each additional unit of output is more expensive for the firm to make than the previous units of output (rising marginal cost).

This chain of reasoning is very important because it clearly shows the linkage from the firm’s production decisions and production constraints to its costs and the behavior of its cost curves.

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3.

4.

Fixating on fixed costs. Students should be aware of how fixed costs affect pricing decisions made by firms: • Why are some consumer products cheaper to buy in bulk? The students should be aware that if packaging costs comprise a significant proportion of the total cost of an item, then an increase in the ratio of product to packaging lowers the cost per unit. The firm can be more competitive and still retain profitability if it passes some of the savings on to the customer through a lower unit price.

Do firms produce where the ATC (or MC) curve is at its minimum? Students frequently ask a variation of this question. Students who ask this question should be praised because they are clearly thinking ahead and trying to use what they are learning to better understand the real world around them. However, you need to be clear to these students that costs are essentially half of the picture. Firms are in business for one reason, to maximize their profit. Profit equals revenue minus cost, so in order to maximize their profit, firms need also to be concerned with their revenue. You can intuitively tell the students that the next chapters “cover the revenue side of the picture” by looking at how the market structure in which a firm competes affects the firm’s revenue and hence affects its decisions.

Firms want to minimize the cost of producing a given level of output, but the level of output that maximizes profit may not be at the minimum of any cost function.

5. Discuss the following in terms of fixed costs, the short run and the long run: In agricultural markets, firms hesitate to be early adopters of new technologies embodied in new capital equipment, which can be quite expensive. But once they are proven to increase productivity, firms rush to adopt them and firms that don’t (or can’t) will have difficulty surviving. Equipment is a huge fixed cost for farmers. Committing to a particular piece of equipment is a decision they will be stuck with for a while, and making the wrong choice may make them a higher cost producer. A smart farmer could buy what turns out to be the wrong piece of equipment because the new technology perhaps proved less durable than expected. This farmer might be unable to reverse that choice in time to save the farm if market conditions are overall poor.

6. Suppose you open a restaurant. Which inputs are fixed and variable in the short run?

When might you hit the long run and have to make new decisions? Labor, food, and other raw materials, some portion of the utility bills, advertising all might be examples of variable inputs. The building and the equipment, whether owned or leased, are typically fixed inputs.

When the lease is up, the firm gets to decide whether to renew, shut down, or go to a smaller space or a bigger space. Ask students to describe what market conditions might lead to each of the above. Why do they think so many restaurants fail?

7. Are firms that survive over long periods of time simply lucky or smarter than other firms? Sometimes the capital choice a firm makes determines its survival and it can’t change the choice easily once made. Unexpected changes in the economy or technology create winners and losers based on past capital decisions.

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PERFECT COMPETITION

The Big Picture Where we have been: Chapter 12 relies heavily on the productivity and cost analysis material of Chapter 11, the marginal analysis and efficiency issues introduced in Chapter 2 and Chapter 5, and the concept of economic profit introduced in Chapter 10.

Where we are going: Chapter 12 is the first of four chapters that explore the price and output decisions of firms under various market characteristics. Chapter 12 studies perfect competition, Chapter 13 studies monopoly, Chapter 14 studies monopolistic competition, and Chapter 15 studies oligopoly. All four chapters use cost curves, marginal analysis, and the concept of efficiency.

New in the Thirteenth Edition The introduction still focuses on the app market, but has been lightly edited. The Economics in the News that used to focus on the exit of record stores now focuses on the entry of record stores given the comeback of vinyl among some consumers. The final Economics in the News still focuses on the app market but now considers Apple’s decision to off free app development curriculum to high school and colleges.

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Lecture Notes

Perfect Competition • • •

I.

Firms in perfect competition face the maximum amount of competition because there are many competing firms, each of which produces an identical product.

Firms in perfect competition maximize their profit by producing where MR = MC. Perfect competition leads to an efficient allocation of resources.

What is Perfect Competition?

• • • •

Perfect competition is an industry in which Many firms sell identical products to many buyers There are no restrictions on entry into the industry Established firms have no advantage over existing ones Sellers and buyers are well informed about prices

How Perfect Competition Arises •

These characteristics of perfect competition arise when the minimum efficient scale for a firm is small relative to the size of the entire market. The minimum efficient scale is the smallest output at which long-run average costs are minimized.

What markets satisfy the characteristics of perfect competition? Have the students consider the markets for goods with which they are familiar to see if any meet the strict criteria for perfect competition.

The markets that come closest are agricultural markets, though others such as lawn service, plumbing, gas stations, and so on, also come close. Students sometimes “worry” that these markets are not exact examples of perfect competition. Reassure them that the model of perfect competition gives us a great deal of understanding into the workings of extremely competitive real world markets and the real world firms in the markets.

If there aren’t really any perfectly competitive markets, what use is studying perfect competition? The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets.

Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a much fancier model! Economists use the model of perfect competition in a similar way to understand our economic world. Emphasize to students that, although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

Price Takers •

Firms in perfect competition are price takers, meaning that a firm that cannot influence the market price and so it sets its own price equal to the market price.

What is a price taker? Spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are “price takers.” On the one hand, they could offer to sell for a lower price, but they’d be giving profits away because they can sell all they want at the going market price. On the other hand, they can ask for a higher price but not even one consumer will pay because consumers know where to buy an exact substitute at a lower price. .

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Economic Profit and Revenue • • •

Firms operating in perfect competition seek to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total opportunity cost of production Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases.

The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.

II. The Firm’s Output Decision Marginal Analysis and the Supply Decision • •

The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit.

Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the marginal revenue (which remains constant with output) to the marginal cost (which changes with output) of producing different levels of output.

• When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of producing one more unit, so the firm increases its output to increase its profit.

• When MR < MC, then the extra cost of producing one more unit exceeds the extra revenue from selling one more unit, so the firm decreases its output to increase its profits • When MR = MC, then the extra cost of producing one more unit equals the extra revenue from selling one more unit, so the firm’s profit is maximized at this level of output.

• In the figure the firm produces 4 units of output because that is the quantity that sets the firm’s marginal cost equal to its marginal revenue, that is, MR = MC. The firm then charges the going market price of $30 for its good.

What’s the point? Students find the topic of competitive market dynamics challenging. Part of their problem is that understanding the dynamics requires a strong understanding of the cost curves of the previous chapter, yet many of them still have only a shaky grasp of that important material. So emphasize the cumulative nature of economics and remind the students of the huge payoff from mastering material a bite at a time.

You also can help your students by emphasizing the two primary goals of this chapter: (1) To derive the market supply curve in a competitive industry and (2) to deepen your students’ understanding of how competition among self-interested consumers and producers will move society’s resources from less valued uses to more highly valued uses, achieving an efficient allocation in the eyes of society.

Temporary Shutdown Decision •

The firm will temporarily shut down in the short run when price falls below the shutdown point, which is the output and price that just allows the firm to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the .

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•

firm’s loss would be greater than if it shut down. (The loss when the firm shuts down is equal to its fixed cost.)

The firm will continue operating in the short run even if it incurs an economic loss as long as the price exceeds the minimum AVC.

Why would a restaurant open on days it knows business will be bad? Monday is typically the slowest day in the restaurant industry. So why do so many restaurants stay open on Monday? The answer is that even if a restaurant incurs an economic loss on Monday, it still might increase its total profit by remaining open. The point is that as long as the restaurant can cover all its variable costs—the cost of the food, the cost of the servers, and so on—it likely will be able to pay some of its fixed costs using the revenue left over after paying its variable costs. As long as the restaurant can pay some of its fixed costs on Monday, its total profit by staying open exceeds what its total profit would be if it closed. So losing money on Monday might be good business!

Students often have a hard time understanding why operating at an economic loss can be the best action for a firm owner. The key is emphasizing: • The firm’s short-run decisions are made after some irreversible commitments have generated sunk costs.

• The firm considers only avoidable future costs when making decisions. Unavoidable costs have no impact on the decision (other than to learn from them).

• For the firm to continue to produce output, the firm needs only to receive revenues that exceed any avoidable costs, not necessarily all total costs.

Basically, the goal of profit maximization does not guarantee that the firm will earn a positive economic profit in the short run. Sometimes the best the firm can do is to minimize its economic loss.

The Firm’s Supply Curve •

•

As long as the firm remains open, it produces where MR = MC. So the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero.

The figure shows the firm’s supply curve as the heavy dark line.

• At prices less than the minimum average variable cost, which equals P in the figure, the firm shuts down and supplies zero.

• At prices greater than the minimum average variable cost, the firm supplies along its marginal cost curve. Hence the firm’s marginal cost curve is its supply, indicated in the figure by the S = MC curve.

III. Output, Price, and Profit in the Short Run The short run is a situation in which the number of firms is fixed. In the short run, market demand and market supply interact to determine the price and quantity produced in a perfectly competitive market.

Market Supply in the Short Run •

The short-run market supply curve shows the quantity supplied by all the firms in the market at each price when each firm’s plant and number of firms remain the same. The quantity supplied in .

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the industry at any price is the summation of all quantities supplied by each firm at that price, so the short-run industry supply curve is the horizontal summation of all the firms’ supply curves.

Short-run Equilibrium •

Market demand and short-run market supply determine the market price and market output. Each firm takes the market price as given, and produces its profit maximizing output.

A Change in Demand • • •

Changes in market demand influence the output and the entry or exit decisions made by firms.

An increase in market demand shifts the market demand curve rightward and raises the market price. Each firm responds by increasing its quantity supplied.

A decrease in market demand shifts the market demand curve leftward and decreases the market price. Each firm responds by decreasing its quantity supplied.

Profits and Losses in the Short Run •

In the short run, even though firms attempt to maximize profit, they may end up breaking even or incurring an economic loss. The total economic profit (or loss) is equal to (P − ATC) × q.

• If the price exceeds the ATC, the firm makes an economic profit (as illustrated in the figure).

• If the price equals the ATC, the firm “breaks even” by making zero economic profit. In this case, the entrepreneur makes a normal profit.

• If the price is less than the ATC, the firm incurs an economic loss.

An Economics in Action application considers the situation of Harley Davidson after a decrease in the market demand. Harley Davidson cut production and laid off workers. One plant was temporarily idled and other jobs were lost permanently.

IV. Output, Price, and Profit in the Long Run In the short run, a firm might break even, earn an economic profit or incur a loss. Because of entry and exit, in the long run a firm can only break even.

Entry • •

•

Economic profit motivates firms to enter the industry, thereby increasing the market supply.

When the market supply curve shifts rightward, the market price falls. Eventually the price falls to equal the minimum ATC for each firm in the industry and firms have adjusted their plant size so they are producing at the minimum long-run average cost. At this price, firms in the industry no longer make an economic profit and so firms no longer enter the industry. The figure illustrates this long-run equilibrium. In the figure, LRAC is the long-run average cost curve and SRAC is the shortrun average cost curve.

One difference between the old and new market equilibriums is that the number of firms in the .

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industry has risen and total quantity produced in the industry has increased.

Exit • •

The effects of a decrease in market demand are the opposite of those outlined above.

In the long run, competitive firms make zero economic profit (price = average total cost) so that their owners make a normal profit.

Long Run Equilibrium • •

Long run equilibrium in a competitive market occurs when there is zero economic profit and entry and exit have stopped.

Because markets are constantly experiencing new changes and shocks, it is rare to see one in a state of long-run equilibrium, but each competitive markets reacts to any new changes by pushing toward it.

Profit as a “signal”: When demand for a good increases so that the existing firms in an industry make an economic profit, the economic profit indicates that consumers are willing to pay a higher price for the good than they were willing to pay before the demand increased. The economic profit for the firms is a signal from the consumers to the owners of firms in other industries that society now values the availability of the good more highly than the availability of goods from those other industries. These selfinterested firm owners choose to enter the industry in order to make an economic profit. Their selfinterested decisions promote the social interest by using more resources to produce those goods that are more highly valued by society. The dynamic behavior of a perfectly competitive market characterizes the “invisible hand” coined by Adam Smith.

Why would a firm stay in business if profit is zero? It is likely that you will hear this question from at least one of your students. Remind them that the profit we’re measuring is economic profit. Zero economic profit doesn’t necessarily mean that the firm isn’t making any money. Rather, zero economic profit means that the profits the accountant is reporting is exactly the same as the value of the firm’s best alternative. If the firm were to move to its best alternative, it would make the same amount of profit. If a firm is making zero economic profit, there isn’t any incentive to go anywhere else as there isn’t any place that would generate a higher return for the firm. You may need to continue reminding your students of this throughout this chapter.

An Economics in Action feature examines entry and exit using the personal computer market and the farm equipment market.

V. Changes in Demand and Supply as Technology Advances Change in Demand •

Technological change can increase demand if it creates new applications for a product or new products. Technological change can also decrease demand if new ways of doing things or new products displace previous ones.

• If demand increases, the price and economic profit rise. The economic profit leads to entry, which increases market supply and causes the price to fall so that eventually firms again make zero economic profit. The number of firms is greater than before the increase in demand.

• If demand decreases, the price falls and economic losses are created. Firms exit the market, which raises the price and decreases the remaining firms’ economic losses. Eventually the price rises so that the surviving firms make zero economic profit. The number of firms is less than before the decrease in demand.

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An Economics in the News case explores the effects of an increase in demand for vinyl records on the decisions of record stores.

Change in Supply •

• •

New, cost-saving technologies typically require new plant and equipment. Consequently it takes time for new technology to spread throughout an industry. Firms that adopt the new technology lower their costs and their supply curves shift rightward. The price of the good falls but the firms with the new technology make an economic profit.

Firms using the old technology incur economic losses. These firms either adopt the new technology or else exit the industry. In the long run, all the firms use the new technology and make zero economic profit.

Changes in technology brings only temporary economic profit to producers, but the lower prices and better products that technological advances bring are permanent gains for consumers.

An Economics in the News case explores the implications of technological changes that have created falling costs to sequence DNA. Do firms in perfectly competitive markets advertise? Firms in perfectly competitive markets have no incentive to advertise because their product is indistinguishable from the output of rival firms. Industry associations will sometimes advertize to increase demand for the product as a whole. Brainstorming all the ads for agricultural products such as “Pork: the other white meat,” and all the varieties of milk ads can be fun, but the point is that it isn’t a pork producer or a dairy farmer creating the ad, but all of the pork producers or dairy farmers paying dues to an industrial organization that then creates the ads. Successful advertisements might lead to an economic profit in the short run, but in the long run entry will force the firms back to zero economic profit.

VI. Competition and Efficiency Efficient Use of Resources •

Resource allocation in a market is efficient when society values no other use of the resources more highly. Resource use is efficient when production is such that the marginal social benefit of the good equals the marginal social cost of the good.

Choices, Equilibrium, and Efficiency •

•

Consumers allocate their budgets to get the most value out of them. Because consumers get the most value out of their budget, a consumer’s individual demand curve for a good is the consumer’s marginal benefit curve for the good. If no one else benefits from the good other than the consumers, then, as shown on the figure, the market demand curve for a good is the marginal social benefit curve.

Firms maximize their profits in order to get the most value out of their resources. Firms make choices across all possible allocations of their resources. A firm’s supply curve for a good is its marginal cost curve. If all the costs of production of the good are paid by the producers, then, as shown in the figure, the market supply curve for a good is the marginal social cost curve. .

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In a competitive equilibrium, the quantity demanded equals the quantity supplied. If there are no externalities, the demand curve is the same as the marginal social benefit curve and the supply curve is the same as the marginal social cost curve, so at the competitive equilibrium, the marginal social benefit equals the marginal social cost. Resource use is efficient. Because resources are used efficiently, at the competitive equilibrium there is no other allocation of resources that will generate greater net benefits to society. The figure shows this outcome, where resource use is efficient at the equilibrium quantity of 3,000 units.

Watching the work of the invisible hand: The power of the market to make firms respond to consumers’ changing demands becomes visible to the student in this chapter. When you teach the dynamics of firm entry and exit, do the analysis with a specific (and current) example with which the students can identify.

Have them pick an industry that has grown and largely died in their lifetime (for me, VCRs, for them, DVDs at Blockbuster, or video cameras or film cameras). What has replaced it and how is society served by failure as well as success?

Economics in the News analyzes Apple’s decision to offer free curriculum to high schools and colleges interested in teaching app development to their students. It explains how the rapid expansion of smartphones has increased the demand for apps while the recruitment of new app developers increases supply.

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Additional Problems 1.

Bob’s is one of many burger stands along the beach. Figure 12.1 shows Bob’s cost curves. a. If the market price of a burger is $4, what is Bob’s profit-maximizing output? b. Calculate the economic profit that Bob’s makes. c. With no change in demand or technology, how will the price change in the long run?

2.

Lucy’s Lasagna is a price taker that has the costs shown in the table. a. If lasagna sells for $7.50 a plate, what is Lucy’s profit-maximizing output? b. What is Lucy’s shutdown point? c. Over what price range will Lucy leave the lasagna industry? d. Over what price range will other firms with costs identical to Lucy’s enter the industry? e. What is the price of lasagna in the long run?

Output (plates per hour) 0 1 2 3 4 5

Total cost (dollars per hour) 5 20 26 35 46 59

Solutions to Additional Problems 1.

a.

b.

c.

Bob’s profit-maximizing quantity is 300 burgers a day. Bob’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $4 a burger. Marginal cost is $4 when 300 burgers a day are produced.

Bob’s economic profit is $300 a day. Profit equals total revenue minus total cost. Total revenue equals $1,200 a day ($4 a burger multiplied by 300 burgers). The average total cost of producing 300 burgers is $3.00 a burger, so total cost equals $900 a day ($3.00 multiplied by 300 burgers).

Profit equals $1,200 minus $900, which is $300 a day.

The price will fall in the long run to $2.80 a burger. At a price of $4 a burger, firms make economic profit. In the long run, the economic profit will encourage new firms to enter the burger industry.

As they do, the price will fall and economic profit will decrease. Firms will enter until economic profit is zero, which occurs when the price is $2.80 a burger (price equals minimum average total cost).

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a.

b.

c.

d.

e.

Lucy’s profit-maximizing output is 2 plates an hour. Lucy’s maximizes its profit by producing the quantity at which marginal revenue equals marginal cost. In perfect competition, marginal revenue equals price, which is $7.50 a plate. Marginal cost is the change in total cost when output is increased by 1 plate an hour. The marginal cost of increasing output from 1 to 2 plates an hour is $6 ($26 minus $20). The marginal cost of increasing output from 2 to 3 plates an hour is $9 ($35 minus $26). So the marginal cost of the second plate is half-way between $6 and $9, which is $7.50.

Marginal cost equals marginal revenue when Lucy produces 2 plates an hour.

Lucy’s shutdown point is at a price of $10 a plate. The shutdown point is the price that equals minimum average variable cost. To calculate total variable cost, subtract total fixed cost ($5, which is total cost at zero output) from total cost. Average variable cost equals total variable cost divided by the quantity produced. For example, the average variable cost of producing 3 plates is $10 a plate. Average variable cost is a minimum when marginal cost equals average variable cost. The marginal cost of producing 3 plates is $10. So the shutdown point is a price of $10 a plate.

Lucy will leave the industry if in the long run the price is less than $11 a plate. Lucy’s Lasagna will leave the industry if it incurs an economic loss in the long run. To incur an economic loss, the price will have to be below minimum average total cost. Average total cost equals total cost divided by the quantity produced. For example, the average total cost of producing 2 plates is $13 a plate.

Average total cost is a minimum when it equals marginal cost. The average total cost of producing 3 plates is $11.67, and the average total cost of producing 4 plates is $11.50. Marginal cost when Lucy's produces 3 plates is $10 and marginal cost when Lucy's produces 4 plates is $12. At 3 plates, marginal cost is less than average total cost; at 4 plates, marginal cost exceeds average total cost.

So minimum average total cost occurs between 3 and 4 plates—$11 at 3.5 plates an hour.

Firms with costs identical to Lucy’s will enter at any price above $11 a plate. Firms will enter an industry when firms currently in the industry are making economic profit. Firms with costs identical to Lucy's will make economic profit when the price exceeds minimum average total cost, which is $11 a plate.

The price in the long run is $11 a plate. At $11 a plate, firms in the industry make zero economic profit.

Additional Discussion Questions 1.

Why do firms do what they do? Students should see how a clear understanding of a perfectly competitive market justifies firm behavior that otherwise might appear somewhat peculiar: Late night TV is full of zany TV commercials with firm owners who claim “I must be crazy, because I’m losing money on every sale!” Why do they advertise to increase sales if they’ll cause the owner to lose even more money? At first, it appears that these owners must be lying about “losing money on every sale.” Yet their unlikely claim is potentially true, as the various firms in their industry may currently face a market price above AVC, but below ATC in the short run. In this case they would remain in business and continue advertising, despite “losing money on every sale” because they are earning revenues above their variable costs to at least help contribute toward paying their fixed cost obligations to their creditors.

Why do the same farmers always complain of losing money but never seem to exit the industry? Point out that agriculture is a collection of highly competitive markets where farming operations typically have an extremely high capital-to-labor ratio. This fact makes the typical farm’s ratio of fixed costs to variable costs very high relative to most industries.

Also, much of a farmer’s capital is in the form farmland, which is difficult to sell during .

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falling agriculture prices, lengthening the farmer’s short run time frame. In this case, the dollar difference between market price and minimum AVC will be rather large. As long as market price exceeds AVC, the farmer will minimize losses by continuing to produce output over an extended short run time frame.

2.

What is implied about efficiency if the average cost of producing a good exceeds the price people are willing to pay for it? Remind the students that a firm’s cost curves reflect the opportunity cost to society of the firm using the resources to make the goods in its market (the resources could be making goods in some other market that could bring benefits to society). The demand curve reflects the value society places on each quantity of goods produced. If the price people are willing to pay is determined by the market supply and demand and the going market price is less than the opportunity cost of producing the last unit of the good, using more resources to increase output creates fewer net benefits for society than could be generated if the resources were used elsewhere in other markets.

What happens to the resources that were used by a firm for production when that firm exits the industry? Point out that when price falls below ATC, this generates an economic loss for the firm. This is a signal from a society of consumers to the owner of the resources that he or she will benefit from reallocating the resources to making different goods and services from the same resources. Society also stands to benefit from this switch.

How can an increase in net benefits to society be generated from the systematic destruction of firms leaving the market? A famous economist named Joseph Schumpeter coined the phrase “creative destruction” to describe the dynamics of a competitive market.

While the productive capacity of a perfectly competitive industry facing declining consumer demand is ultimately destroyed, the resources themselves are not destroyed. They are simply released to firms in other markets to create goods and services that are relatively more valuable to society. This “destruction” of an industry creates goods of greater social value in another industry. That is Schumpeter’s “creative destruction.”

3.

What makes all the self-interested firms adopt the latest available technology for producing at the lowest opportunity cost possible over time? Emphasize that competitive firms cannot increase their economic profits by raising their price, so they must search for ways to increase economic profit through lowering production costs. This means that firms are constantly seeking out the latest production technologies to find a cost advantage over their competitors. If the other firms failed to adopt this low-cost production technology, they would suffer an economic loss when those that do adopt the technology lower their prices to increase market share. Firms that refuse to adopt the technology must then match a lower market price to retain their market shares, causing them to bear an economic loss and face an eventual exit from the market.

4.

Discuss whether there are economies of scale or diseconomies of scale in class size at colleges and universities. Does it matter if the “output” is measured in tuition dollars and costs or in student success as measured by grades? Does technology impact the answer? This situation can be fun to explore. Can a great teacher supported by excellent technology be best used in a huge lecture class? Are there some types of instruction, like experimental labs, where increasing class size might lead to disaster? Why do colleges advertise their average class size and do parents and students care? How might the educational “plant” and equipment differ to support various choices in class size?

5.

Using the global corn market, consider the impact of increasing demand for ethanol made from corn in the short and long run. The increase in demand for ethanol raises the price of corn and thereby increases corn farmers’ economic profit…at least in the short run. .

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But in the long run, the economic profit leads existing farmers to plant more corn and more corn farmers to enter the. These long-run changes increase the supply of corn, thereby lowering the price of corn and decreasing corn farmers’ economic profit. Entry (and expansion) continues until, in the long run, corn farmers’ economic profit equals zero. At that point entry ceases and the corn market is back in long-run equilibrium.

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MONOPOLY

The Big Picture Where we have been: Chapter 12 on perfect competition has shown the student how firms make output and pricing decisions under competitive market assumptions. Chapter 13 explains how a firm with monopoly power makes those same decisions. Chapter 13 evaluates the efficiency of monopoly relative to perfect competition. It also covers regulation of a natural monopoly.

Where we are going: Chapter 14 describes firms and industries in monopolistic competition. Chapter 15 fills in the middle of the spectrum with a study of oligopoly. The material discussing a monopoly’s downward-sloping demand curve and resulting downward sloping marginal revenue curve is used in the next chapter in the context of a firm in monopolistic competition. The result that a monopoly can earn an economic profit is used in Chapter 15 as the explanation why oligopolistic firms want to collude to raise their prices and decrease the quantity they produce.

New in the Thirteenth Edition Many of the applications have been updated. The Economics in the News and Economics in Action applications have been updated with new data. The Economics in Action on information age monopolies now focuses on Microsoft’s dominance in operating systems and Google’s in search. The Economics in Action on price discrimination has been updated to more current Disney World ticket pricing. The Economics in the News on Microsoft has been updated to reflect the Windows 10 release. The final Economics in the News still focuses on Google’s potential misuse of its monopoly power, but now addresses new EU charges of anti-competitive behavior.

© 2018 Pearson Education, Inc

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Lecture Notes

Monopoly • • • • •

I.

A monopoly is a market with a single firm that is protected by barriers to entry.

A monopoly maximizes its profit by producing where MR = MC and then using its demand curve to set its price.

Price-discriminating monopolies charge a higher price to customers with a higher willingness to pay.

Compared to a competitive market, a monopoly sets a higher price, produces a smaller quantity, and converts consumer surplus into economic profit.

Natural monopolies can be regulated by the government.

Monopoly and How It Arises

A monopoly is a firm that produces a good or service for which no close substitute exists and which is protected by a barrier that prevents other firms from selling that good or service.

How a Monopoly Arises

A monopoly has two key features: • No Close Substitutes: There are no close substitutes for the good or service.

• Barriers to Entry: A constraint that protects a firm from potential competition is called a barrier to entry. There are three types of entry barriers: • Natural barriers to entry create a natural monopoly, which is an industry in which economies of scale enable one firm to supply the entire market at the lowest possible cost.

• An ownership barrier to entry occurs if one firm owns a significant portion of a key resource.

• Legal barriers to entry create a legal monopoly, which is a market in which competition and entry are restricted by the granting of a public franchise (an exclusive right is granted to a firm to supply a good or service—the U.S. Postal Service has a public franchise to deliver first-class mail), a government license (when the government controls entry into particular occupations, professions and industries—a license is required to practice law), a patent (an exclusive right granted to the inventor of a product or service) or a copyright (exclusive right granted to the author or composer of a literary, musical, dramatic, or artistic work). In the U.S., patents last twenty years, encouraging innovation and stimulating invention.

Who has to have a license to produce? There are many examples of government licensing. Licensing can protect consumers from fraud and abuse, but it can also hurt consumers by preventing competition from producing an efficient allocation of resources. Have the students debate the merits of the following licensing arrangements: 1) Doctors can receive a medical license to practice medicine only by graduating from an AMA-approved medical program; 2) Lawyers can practice law only after passing an extensive Bar Exam; 3) Cab drivers in New York City can operate a taxi only if they have purchased a medallion from the city, of which there are a finite number; 4) Beauticians in many states cannot operate a beauty parlor without a state certification that requires training in sanitary practices as well as other courses completely unrelated to their profession (such as civics and history courses).

What’s the advantage of patents? Granting an innovator a monopoly to the innovation increases the incentives to innovate. But the evidence whether monopoly leads to greater innovation is mixed. Consider the struggle for developing countries with populations dealing with epidemics such as AIDS. In the developed countries in which they operate, pharmaceutical companies are granted legal barriers (patents) on their drugs, granting them a legal monopoly and enabling them to earn a high economic profit once they bring a new and successful medicine to market. The anticipation of this profit provides the incentive .

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for these firms to undertake the expensive (currently estimated at approximately $900 million per approved drug) and risky development of innovative cures for the terrible diseases afflicting mankind, such as AIDS. However, once the new medicines are made available, the absence of competition means the price is high, which decreases the use of these new medicines, especially among the population of the poorer, developing nations that have been hit the hardest by these diseases. So, once the drug is discovered, the monopoly creates a deadweight loss but without the economic profit the monopoly brings, the drug might not have been discovered. There is a tradeoff between current sufferers, who want a low price, and sufferers in the future, who want new and better medicines developed.

The Economics in Action case considers how the information age has led to the creation of new natural monopolies and now focuses on Microsoft’s dominance in the operating systems market and Google’s dominance in search. These firms have high fixed costs but almost zero marginal costs. These same information age technological changes have hurt other monopolies such as the U.S. Postal Service, with competition from FedEx, UPS, email, and online payments systems. Local cable television providers now face competition from satellite and phone companies as well as streaming services.

Monopoly Price-Setting Strategies • •

A single-price monopoly is a firm that sells each unit of its output for the same price to all its customers.

Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.

II. A Single-Price Monopoly’s Output and Price Decision Price and Marginal Revenue •

• •

The demand curve facing a monopoly Quantity Total Marginal firm is the market demand curve. Total Price demanded revenue revenue revenue (TR) is the price (P) multiplied $4 0 $0 by the quantity sold (Q). Marginal $3 revenue (MR) is the change in total $3 20 $60 revenue resulting from a one-unit $1 increase in the quantity sold. $2 40 $80 The table shows the calculation of TR −$1 and MR. $1 60 $60 A key feature of a single-price monopoly is that MR < P at each quantity so the MR curve lies below the demand curve. MR < P because a single–price monopoly must lower its price on all units sold to sell an additional unit of output.

Why is MR below the price? While the formula isn’t difficult, students often have trouble understanding this concept intuitively. If a firm sells output for $2, why aren’t they getting $2 of revenue for each unit of output they sell so that marginal revenue is $2? Remind students that we are assuming that the monopoly charges the same price to all consumers. As in the table above, if on any given day, every consumer is paying $2 for output, 40 units are demanded and total revenue is $80. If the monopoly decides it wants to sell more than 40 units the next day, it must lower the price to do so. The monopoly is NOT simply lowering the price to $1 for units 41 through 60. Rather, the monopoly lowers the price on ALL units it will sell the next day. As a result, units 1 through 40 that customers used to pay $2 for will now be sold for only $1. That’s a loss of $1 on each of those 40 units for a revenue loss of $40. Part of that revenue loss is offset by the sales of units 41 through 60. Since the firm gains $1 in revenue from the sale of each of those units, there is a revenue gain of $20. A revenue loss of $40 (from lowering prices) compared with a revenue gain of $20 (from selling more output) generates a net revenue loss of $20, and (when divided by the change in

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output from 40 to 60) a marginal revenue of negative $1. For visual learners, showing these areas of revenue gain and revenue loss should also help (similar to Figure 13.2 in the text).

Marginal Revenue and Elasticity • •

• •

If demand is elastic, the MR is positive. A decrease in the price will result in a proportionately greater increase in quantity, generating an increase in revenue.

If demand is unit elastic (as it is at the midpoint of a linear demand curve), the MR equals zero. A change in the price will result in a proportionate change in quantity, generating no change in revenue. If further increase in revenue is not possible from changing price, this is also the point where revenue is maximized.

If demand is inelastic, MR is negative. A decrease in price will result in a proportionately smaller increase in quantity, generating a decrease in revenue.

A single-price monopoly never produces in the inelastic part of its demand because if it did, the firm could increase its total profit by decreasing its output, which would raise its total revenue and decrease its total cost.

But if a monopoly is the only producer so there are no substitutes, isn’t demand always inelastic? This question is common. As the only producer of a good, a monopoly does have some control over the price it charges for output, and students understand that conceptually. For example, when you go to the movie theater, you know you’re likely to pay $5 or more for a tub of popcorn, even though you could buy the same amount of popcorn at the grocery store for $1 or less. Because you’re stuck at the movie theater with whatever options they offer, consumers end up paying a higher price. In other words, because there are fewer substitutes at the theater, demand for popcorn is less elastic. However, that fact does NOT mean that the demand for popcorn at a movie theater universally has an elasticity of demand that’s less than one.

Even if demand for a monopoly’s product is fairly inelastic, the demand still has some ranges where elasticity is greater than one (anywhere above the midpoint on a linear demand curve, for example).

Price and Output Decision •

•

To maximize its profit, a monopoly produces the level of output where MR = MC. The monopoly then uses its demand curve to set the price at the highest price for which it will be able to sell the quantity it produces. In the figure, which uses the demand and MR schedules from the table above, the firm produces 20 units of output and sets a price of $3 per unit.

The firm makes an economic profit if P > ATC, which is the case for the firm in the figure. The monopoly can make an economic profit even in the long run because the barriers to entry protect the firm from competition. However, a monopoly firm is not guaranteed an economic profit. In the short run and/or long run, it might make zero economic profit, (P = ATC) or in the short run, it might incur an economic loss (P < ATC).

Joan Robinson and Paul Samuelson: The classic monopoly diagram provides a good opportunity to tell your students about the contribution of one of the most brilliant economists of the 20th century, Joan Robinson. This diagram first appeared in her book, The Economics of Imperfect Competition, published in 1933 when she was just 30 years old.

Women are still not attracted to economics on the scale that they’re attracted to most other disciplines, so the opportunity to talk about an outstanding female economist shouldn’t be lost. Joan Robinson was a .

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formidable debater and reveled in verbal battles, a notable one of which was with Paul Samuelson on one of her visits to MIT. Anxious to make and illustrate a point, Samuelson asked Robinson for the chalk.

Monopolizing the chalk and the blackboard, the unyielding Robinson snapped, “Say it in words young man.” Samuelson meekly obeyed. This story illustrates Joan Robinson’s approach to economics: work out the answers to economic problems using the appropriate techniques of math and logic, but then “say it in words.” Don’t be satisfied with formal argument if you don’t understand it. Your students will benefit from this story if you can work it into your class time.

III. Single-Price Monopoly and Competition Compared Comparing Price and Output •

• •

Perfect Competition: The market demand curve (D) in perfect competition is the same demand curve that the firm faces in monopoly. The market supply curve (S) in perfect competition is the horizontal sum of the individual firm’s marginal cost curves. This supply curve also is the monopoly’s marginal cost curve, so in the figure above the supply curve is labeled MC. In a competitive market, equilibrium occurs where the quantity demanded equals the quantity supplied. In the figure above, the competitive equilibrium quantity is 30 units and the competitive equilibrium price is $2.50 per unit.

Monopoly: The monopoly produces where MR = MC and sets its price using its demand curve. In the figure, the monopoly produces 20 units of output and sets a price of $3.00 per unit.

Compared to a perfectly competitive industry, a single-price monopoly produces less output and sets a higher price.

Is the monopolist’s marginal cost curve its supply curve? Although most students will be satisfied with the comparison of the monopolist’s marginal cost curve to a competitive market’s supply curve, some students will mistakenly assume that the monopolist’s marginal cost curve is also the monopolist’s supply curve. A monopolist actually has no “supply curve” because there is no single curve that provides information both on the quantity supplied and the price. If the firm produces 20 units of output when it is maximizing profit, that output level is determined by the point where MC = MR. However, the price charged for that output doesn’t come from the MC curve. The price comes from the market demand curve.

As a result, there is no relationship between the quantity supplied and price that is defined by the marginal cost curve.

Efficiency Comparison and Redistribution of Surpluses • •

•

A perfectly competitive industry produces the efficient quantity of output, where MSB = MSC. Because a single-price monopoly produces less output (where MSB > MR = MC = MSC), it underproduces and creates a deadweight loss.

Consumer surplus is smaller with a monopoly than with perfect competition. In the figure above, the consumer surplus under perfect competition is the area under the demand curve and above the competitive equilibrium price of $2.50 per unit. Under monopoly the consumer surplus is the area under the demand curve and above the monopoly price of $3.00.

Though the monopoly creates a deadweight loss, the monopoly’s owners benefit because it earns an economic profit. A monopoly’s owners benefits because the monopoly redistributes some of the consumer surplus away from the consumer and to the monopoly.

Does inefficiency imply less profit? It is important for students to recognize that the source of the inefficiency of a monopoly firm’s output and pricing decision arises from the absence of competition in the market, rather than any change in the behavioral assumptions about the firm owners. All firms maximize profit, but that goal does not imply efficiency when there is less than perfect competition in a market.

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Rent Seeking •

•

Any surplus—consumer surplus, producer surplus, and economic profit—is called economic rent.

Rent seeking is the pursuit of wealth by capturing economic rent.

• Rent seeking can occur when someone uses resources seeking the opportunity to buy a monopoly for a price less than the monopoly’s economic profit.

• Rent seeking also can occur when someone uses resources lobbying the government to create a monopoly. Because of rent seeking, the social cost of monopoly exceeds the deadweight loss it creates.

The resources used in rent seeking are a cost to society that adds to the monopoly’s deadweight loss. Because there are no barriers to entry in the activity of rent seeking, the resources used up can equal the monopoly’s potential economic profit, reducing monopoly profit.

IV. Price Discrimination Price discrimination is the practice of selling different units of a good or service for different prices.

Price discrimination converts consumer surplus into economic profit. To be able to price discriminate, a firm must: • Identify and separate different buyer types.

• Sell a product that cannot be resold

Two Ways of Price Discriminating •

Price discrimination occurs because of people’s different willingness to pay for the good. A firm can charge the same buyer different prices for different units of a good or a firm can charge different prices to different groups of buyers.

• Discriminating Among Groups of Buyers: A firm can charge different customers different prices for the product. Groups with a higher willingness to pay are charged a higher price and groups with a lower willingness to pay are charged a lower price. For example, business airline travelers who have a high willingness to pay and often make last-minute reservations are charged a higher price than leisure travelers, who have a low willingness to pay and often make advance reservations.

• Discriminating Among Units of a Good: A firm can charge a higher price for the first units purchased and a lower price for later units purchased. An example is pizza delivery, where the second pizza is generally cheaper than the first.

Increasing Profit and Producer Surplus • If buyers pay close to the maximum they are willing to pay, a monopoly converts consumer surplus into producer surplus. More producer surplus means more economic profit.

• Economic profit is TR − TC and Producer Surplus is TR − TVC. Therefore Economic Profit = Producer Surplus − Total Fixed Costs. Consequently, for a given level of fixed costs, anything that increases producer surplus increases economic profit.

• Perfect price discrimination occurs if a firm is able to sell each unit of output for the highest price anyone is willing to pay for it. In this case, the price of each unit is the same as the unit’s marginal revenue, so the firm’s (downward sloping) demand curve becomes the same as its marginal revenue curve. Output increases to the point where the demand (= marginal revenue) curve intersects the marginal cost and the efficient quantity is produced. The deadweight loss is eliminated. The firm’s economic profit is the greatest possible. But consumer surplus equals zero because the firm captures the entire consumer surplus.

An Economic in Action feature considers Disney World’s ticket pricing. High prices for the first three days seem to extract most of the consumer surplus.

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Efficiency and Rent Seeking With Price Discrimination • •

The more perfectly a monopoly can price discriminate, the greater the amount of its output and the more efficient the outcome.

Because the producer grabs the entire surplus in perfect price discrimination, rent seeking becomes profitable, and the long-run equilibrium outcome is that rent seekers use up the entire producer surplus.

Can only monopolies price discriminate? The text uses the example of price discrimination by an airline.

Another easy example of price discrimination is movie theaters: The price of watching a movie at 8:00 is higher than the price of watching the same movie at 5:00. But these examples often lead to a very pertinent question from students: “Neither airlines nor theaters are monopolies. So why can they price discriminate?” You need to explicitly tell your students that any firm which has some control over the price it sets has the potential to price discriminate. Monopolies have control over the price it sets, so we discuss price discrimination in the chapter dealing with monopoly. But in the “real world,” many firms other than monopolies, such as airlines and movie theaters, practice price discrimination.

An Economics in the News application describes Microsoft’s launch of Windows 10 and includes pricing data from various sources to explore price discrimination.

V. Monopoly Regulation •

•

•

•

A natural monopoly is an industry in which one firm can supply the entire market at a lower cost than can two or more firms. The definition of a natural monopoly means that the firm’s LRAC curve falls throughout the relevant range of production. As a result, the firm’s MC curve is below its LRAC curve when the MC curve crosses the firm’s demand curve.

The figure shows a natural monopoly with constant marginal costs. A natural monopoly has large economies of scale so that one firm can supply the entire market at lower cost than two firms because the LRAC curve is falling even when the entire market is supplied.

A natural monopoly produces at the lowest possible cost, but as an unregulated monopoly it will raise the price above the competitive price and produce less than the efficient quantity. To try to reap the benefits of the lower costs while avoiding the drawback of a monopoly, natural monopolies are typically given a public franchise (so they are given the right to be a monopoly) but are regulated by a government agency.

The social interest theory says that political and regulatory processes seek out inefficiency, reduce deadweight loss, and allocate resources efficiently. Capture theory says regulation serves the interest of producers who capture the regulators to maximize economic profits.

Efficient Regulation of a Natural Monopoly •

•

An unregulated natural monopoly will produce where MR = MC and use its demand curve to set the highest price for which this quantity is demanded. In the figure, when unregulated, the firm produces Qm and sets a price of Pm. There is a deadweight loss.

A marginal cost pricing rule sets price equal to marginal cost. In the figure, the firm produces Qmc and sets a price of Pmc. This regulation results in an efficient use of resources but the firm’s price is less than its average cost, so the monopoly incurs an economic loss. .

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•

If firms are regulated with a marginal cost pricing rule, they incur an economic loss because the price is less than the average cost. They will have to be paid a subsidy by the government or allowed to price discriminate in order to avoid the economic loss.

Second-best Regulation of a Monopoly •

•

• •

An average cost pricing rule sets price equal to average total cost. In the figure, the firm produces Qac and sets a price of Pac. Because a normal profit is part of the firm’s costs, the firm earns a normal profit. The amount of output, however, is inefficient, though it is closer to the efficient quantity than when the monopoly is unregulated. Government subsidies could offset those losses but would create deadweight losses from the taxes that would have to be increased to pay the subsidies.

Because regulators cannot determine a firm’s exact costs, rate of return regulation is often used.

• Rate of return regulation requires a firm to justify its price by showing that the price enables it to earn a specified target percent return on its capital. When this policy is used, the managers of the regulated firm have the incentive to inflate its costs for beneficial amenities that do not promote efficiency but instead give the managers more amenities.

Because rate of return regulation does not give the firm the incentive to operate efficiently, pricecap regulation is now used more frequently.

A price-cap regulation is a price ceiling—a rule that specifies the highest price the firm is permitted to set. Price cap regulation gives managers an incentive to minimize costs: if the firm decreases its costs and earns an economic profit, the firm will be allowed to keep all (or part) of the profit. Typically price cap regulation also requires earnings sharing regulation, under which profits that rise above a target level must be shared with the firm’s customers.

Economics in the News: The Economics in the News analyzes whether Google leveraged its dominant position in search to highlight its own products and services in search results and to prevent advertisers from moving content to other platforms. It concludes that Google is attempting to perfectly price discriminate and does not appear to be acting against the social interest.

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Additional Problems 1.

The table has the demand schedule for industrial diamonds faced by Dolly’s Diamond Mines, a single-price monopoly. a. Calculate Dolly’s total revenue schedule. b. Calculate its marginal revenue schedule.

2.

Dolly’s Diamond Mines in problem 1 has the total cost schedule in the table. Calculate the profit-maximizing levels of a. Output b. Price c. Economic profit d. Does Dolly’s Mines use resources efficiently?

Explain your answer.

Price (dollars per pound) 2,200 2,000 1,800 1,600 1,400 1,200 Quantity produced (pounds per day) 5 6 7 8 9 10

Quantity demanded (pounds per day) 5 6 7 8 9 10 Total cost (dollars) 8,000 9,000 10,000 11,600 13,200 15,000

3.

Figure 13.1 illustrates the situation facing the publisher of the only newspaper containing local news in an isolated community. The publisher’s marginal cost for the new plant is constant at 20 cents per copy printed. a. What quantity of newspapers will maximize the publisher’s profit? b. What price will the publisher charge for a daily newspaper? c. What is the publisher’s daily total revenue? d. At the price charged for a newspaper, is the demand for newspapers elastic or inelastic?

Why?

4.

In the monopoly newspaper market described in problem 3, a. What is the efficient quantity of newspapers to print each day? Explain your answer. b. When the market is a monopoly, what is the consumer surplus of the readers of the newspaper? c. What is the deadweight loss created by the monopoly newspaper publisher?

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5.

What is the maximum value of resources that will be used in rent seeking to acquire Dolly’s monopoly in problem 1? Considering this loss, what is the total social cost of Dolly’s monopoly?

Solutions to Additional Problems Price (dollars per pound)

1.

a.

b.

2.

a.

b.

c.

2,200

Quantity demanded (pounds per day) 5

Total revenue (dollars per day) 11,000

2,000

6

12,000

1,800

7

12,600

1,600

8

12,800

1,400

9

12,600

1,200

10

12,000

Marginal revenue (dollars per pound) 1,000 600 200 −200 −600

The table above shows the total revenue schedule. Dolly’s total revenue schedule lists the total revenue at each quantity sold. For example, Dolly’s can sell 10 pounds for $1,200 a pound, which gives it total revenue of $12,000 at the quantity 10 pounds.

The table above shows the marginal revenue schedule. Dolly’s marginal revenue schedule lists the marginal revenue that results from increasing the quantity sold by 1 pound. For example, Dolly’s can sell 5 pounds for $2,200 each, which is total revenue of $11,000 at the quantity of 5 pounds.

Dolly’s can sell 6 pounds for $2,000 each, which is $12,000 of total revenue at the quantity of 6 pounds. By increasing the quantity sold from 5 pounds to 6 pounds, marginal revenue is $1,000 a pound ($12,000 minus $11,000).

Dolly’s profit-maximizing output is 5.5 pounds. The marginal cost of increasing the quantity from 5 pounds to 6 pounds is $1,000 a pound ($9,000 minus $8,000). That is, the marginal cost of 5.5 pounds is $1,000 a pound. The marginal revenue of increasing the quantity sold from 5 pounds to 6 pounds is $1,000 ($12,000 minus $11,000). So the marginal revenue from 5.5 pounds is $1,000 a pound. Profit is maximized when the quantity produced is such that marginal cost equals marginal revenue. The profit-maximizing output is 5.5 pounds.

Dolly’s profit-maximizing price is $2,100 a pound. The profit-maximizing price is the highest price that Dolly’s can sell the profit-maximizing output of 5.5 pounds. Dolly’s can sell 5 pounds for $2,200 and 6 pounds for $2,000, so it can sell 5.5 pounds for $2,100 a pound.

Economic profit equals total revenue minus total cost. Total revenue equals price ($2,100 a pound) multiplied by quantity (5.5 pounds), which is $11,550. Total cost of producing 5 pounds is $8,000 and the total cost of producing 6 pounds is $9,000, so the total cost of producing 5.5 pounds is $8,500. So Dolly’s economic profit equals $11,550 minus $8,500, which is $3,050.

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3.

d.

Dolly’s is inefficient. Dolly’s charges a price of $2,100 a pound, so consumers receive a marginal benefit of $2,100 a pound. Dolly’s marginal cost is $1,000 a pound. That is, the marginal benefit of $2,100 a pound exceeds Dolly’s marginal cost.

a.

The profit-maximizing output is 200 newspapers a day. Profit is maximized when the firm produces the output at which marginal cost equals marginal revenue. Draw in the marginal revenue curve. It runs from 100 on the y-axis to 250 on the x-axis. The marginal revenue curve cuts the marginal cost curve at the quantity 200 newspapers a day.

The highest price that the publisher can sell 200 newspapers a day is determined from the demand curve. The price charged is 60 cents a paper.

The daily total revenue is $120 (200 papers at 60 cents each).

Demand is elastic. Along a straight-line demand curve, demand is elastic at all prices above the midpoint of the demand curve. The price at the midpoint is 50 cents. So at 60 cents a paper, demand is elastic.

b. c. d.

4.

a.

b.

c.

5.

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The efficient quantity is 300 newspapers—the quantity that makes marginal benefit (price) equal to marginal cost. With 300 newspapers available, people are willing to pay 40 cents for a paper. To produce 300 newspapers, the publisher incurs a marginal cost of 40 cents a paper.

Consumer surplus is the area under the demand curve above the price. When the market is a monopoly, the price is 60 cents, so consumer surplus equals (100 cents minus 60 cents) multiplied by 200/2 papers a day, so the consumer surplus is $40 a day.

Deadweight loss arises because the publisher does not produce the efficient quantity. Output is restricted to 200, and the price is increased to 60 cents. The deadweight loss equals (60 cents minus 40 cents) multiplied by 100/2 so the deadweight loss is $10 a day.

The maximum that will be spent on rent seeking is $3,050 a day—an amount equal to Dolly’s economic profit. The total social cost equals the deadweight loss plus the amount spent on rent seeking. To calculate the deadweight loss, first calculate the efficient output—the intersection point of the demand curve (marginal benefit curve) and the marginal cost curve. Do this by finding the equations to the two curves and solving them. The efficient output is 8.25 pounds. The deadweight loss equals $1,512.50. The loss to society is $4,562.50 ($3,050 plus $1,512.50).

Additional Discussion Questions 1.

The double-edged sword of a natural monopoly. Emphasize how economic analysis reveals the social benefits and costs of an industry characterized by a downward sloping, long-run LRAC curve. Ask the student the following questions: What is the characteristic of the monopoly market that allows a natural monopoly to potentially produce output at the lowest possible LRAC? The student should see that a lack of competition allows the firm to potentially serve the entire market at a lower unit cost than if it had to share the market with any other number of firms. A multi-firm market would be forced to produce at a higher LRAC. What is the characteristic of a monopoly market that allows a natural monopoly to potentially charge consumers a price premium above long-run LRAC? If the natural monopoly has the freedom to set its own price, the student should identify the lack of competition that prevents the consumer from benefiting from production actually occurring at the lowest LRAC. On the one hand, the lack of competition is the only way to allow society to enjoy a (potentially) more efficient allocation of resources, yet it also allows the firm to

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extract consumer surplus while generating an inefficient resource allocation—a “doubleedged sword.”

2.

Troubles with price discrimination: The ethics of scalping. Get the students to address the realities of arbitrage in secondary markets that arise when the primary seller of a good refuses to price discriminate.

Is it in society’s best interest (economically efficient) to allow the scalping of tickets?

The students should see that ticket scalping is just a form of price discrimination, which is a business practice shown in the text to increase the level of efficiency in resource allocation within a monopoly market context.

Why do the original ticket sellers refuse to price discriminate like the scalpers? There are many possible reasons: • The original seller of the tickets (usually the music group giving the concert or the ticket sellers that are under direct contract for them) may want to avoid the reputation of charging different prices to different people, or different prices at different time intervals before the concert.

• The original seller may not have the ability to distinguish between high and low demand customers, unlike the “scalpers” who sell the tickets standing outside the doors on the day of the concert.

• The original sellers may be very risk averse and prefer to sell every ticket well in advance of the concert date, based on the expectations of sales potential made with the best available information at the time. They may reason that if a concert sells out quickly, the demand for future concerts will increase because more people come to believe that the group is “hot” and a must-see act. However, information about the actual demand for a concert becomes clearer as the concert date draws nearer and the equilibrium price for a ticket may change significantly. Scalpers must gamble that ticket prices will increase when it eventually becomes clear that demand for the event is relatively high. They bear the risk that the original ticket seller would not bear: that the ticket prices may also decrease if it is revealed that demand for the event is relatively low.

Is it “fair” to allow scalping of concert tickets? Remind the students that the practice of price discrimination can increase monopoly profits for the resellers while simultaneously increasing efficiency for society. Remind them also of the principle of opportunity cost and ask them to consider how much efficiency they are willing to give up in the name of “fairness.” Point out that fairness is a normative concept—different people might have different ideas of fairness. For instance, the scalper who sells his or her tickets surely believes that the actions are fair. The purchaser of the scalped ticket might believe that paying above the asked price is unfair but the person is still willing to buy the ticket as long as the scalped price is less than the maximum price he or she is willing to pay.

If it is unfair to scalp tickets because of the way price discrimination transfers consumer surplus to producer surplus, then what about other forms of price discrimination? Ask the students to consider the following scenarios. They should understand that, in each case, there is an identifiable group of consumers who have a different willingness to pay for the product or service mentioned.

• If the costs of projecting a movie are the same at all times of day, why are matinee movie prices lower than evening movie prices for the exact same movie in the exact same theater? Why do movie theaters often give students discounts?

• If the cost of publication is the same for all potential subscribers, then why do magazines and newspapers offer students discounts on subscription prices? .

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If the cost of serving beverages and supplying entertainment (live bands) is the same for both men and women, then why do bars and clubs offer “Ladies’ Night” where women get free drinks or pay no cover charge?

• If the cost of serving food and beverages is the same for all diners, then why do seniors get a price break from restaurants for the exact same meals?

How would you measure the inefficiency of a monopoly? The students should see that the lost potential for consumer and producer surplus could be calculated as deadweight loss, but that is only part of the total loss of benefits. Ask the students: Is there more to the inefficiency of a monopoly than meets the eye? If you are rather brave, you may want to ask the students to play the following game: Show the class a fresh, real five-dollar bill. Announce that it is a monopoly profit that anyone in class can receive simply by submitting the highest, non-zero price bid for it. Mention that even if the highest bid is only one penny, then that person will receive the five-dollar bill. However, everyone else that submits a bid must also pay you the value of that bid, regardless of whether they are successful. (This bid price reflects the cost involved with rent-seeking behavior.) In the case of a tie for highest bid, a run-off bidding contest among the tied high bidders will occur, but their first bid still stands as a debt to you, the holder of the monopoly profit.

How much would YOU bid for this monopoly profit? Ask the students to write down on a small piece of paper their name and the price he or she is willing to bid for the five-dollar bill. They may write a bid of zero cents, but they will not get a chance to win. Announce that you will collect the money from them later (you will have their name and their bid). After collecting the bids, roughly tally them up and announce the winning bid, as well as the total sum of the bids to be collected. There are two possible scenarios to the outcome of this auction: • There is one high bidder, and this bid is usually very close to the monopoly profit offered for sale—there are usually one or two students who want to signal their “devilmay-care” attitude or signal their status as a relatively wealthy student who can afford to play extravagant games.

• There is a tie between two or more students. The resulting run-off bidding is usually very high, because each of the remaining students hasn’t yet fully appreciated the economic notion of sunk costs. In this latter case, do not be surprised if the winning bid is more than five dollars, as the “winner” wants desperately not to lose the full amount of his or her initial bid.

What is the total opportunity cost of the resources used to pursue monopoly profits?

Point out that the bids represent the resources people use (usually through lobbying efforts) to pursue a monopoly market position by convincing government to restrict competition. Ultimately, only one person wins, but all contenders expend resources in the pursuit. That is why all losing bidders had to pay their bid price.

Can we compare the value of lost output in other markets that could have been produced against the value of those goods and services produced specifically for pursuing a monopoly? Emphasize that the goods and services that were used to pursue a monopoly would not have been chosen for production if the monopoly profit hadn’t been offered up for sale in the first place. That is how we can know that rent seeking is inefficient—there was a decline in net benefits for society from forgone production of higher-valued goods. After the discussion is over, give the highest bidder the five-dollar bill in exchange for the bid he or she pledged. (You were warned about having to be brave!) If the highest bid is over five dollars, just state that you will forgive the student his or her debt

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and call it a wash. Then announce that the other bidders are also off the hook, as you were just trying to make the scenario as realistic as possible. Many sighs of relief will be heard.

4.

When the old AT&T had a virtual monopoly on long distance service, it created a rate structure that had high prices M-F 8 am to 5 pm, medium prices M-F 5:01 pm – 11 pm, and low prices M-F 11:01 pm -7:59 am and all day weekends and holidays. How might the differences in elasticities for business phone users and household phone users explain this rate structure? Long distance pricing under the unregulated AT&T monopoly is a great example of price discrimination. Add on to the example the “Reach Out and Touch Someone” campaign to increase residential demand, and price sensitive households across America called Grandma on Sunday evening. Businesses had little ability in that era to shift their demand to other periods and phone service, while expensive, was a small part of their total costs. Both these factors made business demand for long distance phone services relatively inelastic and lead to the high price of long-distance calling during business hours.

5.

Gilead has changed the pricing structure on its essential AIDS medications so that prices are high in industrialized countries, medium in emerging countries, and low in the poorest countries. Discuss whether this is an example of price discrimination and whether resources are efficiently allocated given patents and high drug development costs. This issue could easily be the basis for a good debate or opinion essay. Clearly Gilead is price discriminating. Likely Gilead is increasing its economic profit. Society has a strong interest in creating more innovation and technological change. Perhaps Gilead’s pricing structure can further these goals by increasing the profit from its innovation. This three-tier pricing model could be regarded as “fair” or “unfair” depending on which nation and which part of the health care matrix an agent represents.

6.

How does technological change lead to new competition for old monopolies and sometimes to their failure? Changes at the U.S. Postal Service are widely reported. Kodak filed bankruptcy. Streaming on computers becomes potentially a viable substitute for cable television. These examples certainly help frame an answer to the important question “Does having a monopoly guarantee success?”

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MONOPOLISTIC COMPETITION

The Big Picture Where we have been: Chapter 14 continues the general analysis of the firm’s output and price decision by examining the case of monopolistic competition. This chapter also examines efficiency using the ideas introduced and explained in Chapters 2 and 5, and uses the market concentration measures explained in Chapter 10.

Where we are going: Chapter 15 presents the final market structure, oligopoly. Chapters 16 and 17 examine externalities, public goods, and common resources. Chapter 18 focuses on competitive factor markets. Chapter 19 investigates the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends. The final chapter, Chapter 20, analyzes some of the difficulties in making decisions when information is incomplete. The material presented in this chapter is not used explicitly in the following chapters.

New in the Thirteenth Edition A new chapter introduction and concluding Economics in the News application focus on product differentiation in the market for smartphones. The data in the Economics in Action on 10 industries that operate as monopolistic competition has been updated.

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Lecture Notes

Monopolistic Competition • •

I.

Firms in monopolistic competition face competition from many other firms that produce a similar but differentiated product from its own.

Firms in monopolistic competition maximize their profit by producing where MR = MC.

What Is Monopolistic Competition?

Monopolistic competition is a market structure in which: • A large number of firms compete • Each firm produces a differentiated product • Firms compete on product quality, price, and marketing • Firms are free to enter and exit

Large Number of Firms •

The large number of firms in a monopolistically competitive industry implies that each firm has a small market share, no firm can dictate market conditions, and collusion (conspiring to fix a higher price) is impossible.

Product Differentiation •

Product differentiation means that each firm makes a product that is slightly different from the products of competing firms. Because close but not perfect substitutes exist, some people will pay more for one variety of a product, so the demand curve for the firm’s product is downward sloping.

Competing on Quality, Price, and Marketing • • • •

Product differentiation allows a firm to compete with other firms in product quality, price, and marketing.

Quality: Physical attributes that differentiate a product, including differences in design, reliability, and service provided.

Price: There is a tradeoff between quality and price.

Marketing: The two main forms are advertising and packaging.

An Economics in Action application considers 10 monopolistically competitive industries. The application shows the 4-firm concentration ratios and Herfindahl-Hirschman Index.

Entry and Exit •

With no barriers to entry, firms in monopolistically competitive industries make zero economic profit in the long run.

Examples of Monopolistic Competition •

Examples of a monopolistic industry include audio and video equipment, sporting goods, and jewelry.

Ask students to bring in an empty beverage bottle of their choice. From the pile in the front of the room, have students help separate them into products in competing markets. A surprising large numbers of water bottles will appear, and differences as simple as packaging enter the conversation.

II. Price and Output in Monopolistic Competition The Firm’s Short-Run Output and Price Decision •

The demand curve for a monopolistically competitive firm is downward sloping (similar to the demand curve for a monopoly). The downward sloping demand curve means that the firm’s .

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marginal revenue curve also is downward sloping and lies below the demand curve.

Why do these firms face a downward-sloping demand curve if there are so many substitutes available? Remind the students about the “everything-else-constant” condition that defines a demand curve. Along the demand curve for Nike tennis shoes, the prices of Adidas, Fila, Head, K Swiss, Prince, Reebok, and Wilson tennis shoes are constant. Some people prefer Nike to the other brands and will pay a bit more for Nike. Other people prefer some other brand and will buy Nike only if its price is low enough.

Buyers have brand preferences, but they will switch brands if price differences are large enough. So the higher price of a Nike shoe, the prices of the other brands remaining the same, the smaller is the quantity of Nike shoes demanded—a downward sloping demand.

•

•

•

In the short run, a monopolistically competitive firm makes its output and price decisions just like a monopoly firm. The figure shows a monopolistically competitive firm’s downward sloping demand curve and the downward sloping MR curve, which, as noted, lies below the demand curve.

The firm maximizes its profit by producing the quantity where MR = MC and using the demand curve to set the highest price at which people will buy the quantity it produces. In the figure, the firm produces 20 pizzas per hour and sets a price of $15 per pizza.

The firm earns an economic profit if P > ATC (as is the case for the firm in the figure). If P = ATC, the firm earns zero economic profit, and if P < ATC, the firm incurs an economic loss.

Profit Maximizing Might be Loss Minimizing •

In the short run, profit maximizing quantity of output might be the loss minimizing quantity of output. The text explores the case of Excite@Home.

Long Run: Zero Economic Profit •

•

Unlike a monopoly, firms in monopolistic competition cannot earn economic profit in the long run. If the firms are earning an economic profit, other firms enter the market. Entry continues as long as firms in the industry earn an economic profit. As firms enter, each existing firm loses some of its market share. The demand for each firm’s product decreases and the firm’s demand curve shifts leftward.

Eventually the demand decreases enough so that the firms earn only a normal profit, where P = ATC. Entry then stops. This outcome is illustrated in the figure, in which the firm produces 10 pizzas per hour (where MR = MC) and sets a price of $7.50 per pizza.

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Why do entry and exit shift the demand curve facing the firm? Students seem to have a bit of trouble appreciating that entry and exit change the demand for a firm’s product. You can now haul out your cell phone and return to it as your in-class example. Likely your phone will have a camera. Though the early history is fuzzy—it’s replete with small attempts that led to either small failures or small successes—the first largely successful cell phone/camera was the J-phone marketed in Japan in 1997. In the United States, Sprint had the first success: It sold over 1 million camera phones in 2002. Clearly these phones were wildly popular and inspired imitators. You can draw the figure showing a monopolistic competitive firm earning a large economic profit and tell the students that this was the case with these first phones. But then competitors entered the market. When the second phone entered the market, show how the demand for the first firm was affected by shifting it and its marginal revenue curve leftward. You can easily point out how entry decreased the first firm’s profit. Continue by discussing how further entry shifted the demand curve further leftward until, in the long run, the company was left with only a normal profit.

Monopolistic Competition and Perfect Competition Unlike firms in perfect competition, firms in monopolistic competition have excess capacity and a markup: • Excess Capacity: A firm has excess capacity if it produces less than its efficient scale, the quantity that minimizes its average total cost. In the long run, a firm in perfect competition produces at the minimum ATC but, a firm in monopolistic competition produces less than the quantity that minimizes the ATC. • Markup: A firm’s markup is the amount by which its price exceeds its marginal cost. A firm in perfect competition has no markup but a firm in monopolistic competition charges a price that is greater than its marginal cost of production.

Is Monopolistic Competition Efficient?

•

Firms in monopolistic competition have higher costs than firms in perfect competition, but firms in monopolistic competition produce variety, which is valued by consumers. So compared to the alternative of complete uniformity, monopolistic competition might be efficient.

III. Product Development and Marketing Product Development •

•

Product development is costly, but can bring in additional revenue. New product development allows a firm to gain a temporary competitive edge and economic profit before competitors imitate the innovation. At a low level of product development, the marginal revenue of better products exceed the marginal cost so firms develop more new products. At high levels, the marginal cost exceeds the marginal revenue and so firms develop fewer new products.

Because MR is less than P in monopolistic competition, product development is probably not at its socially efficient level.

Food lore says that buffalo wings started out at a restaurant in Buffalo, New York, and now are on the menu of virtually every bar and casual dining restaurant in the nation. Many other similar examples can be identified. Success breeds imitation in the world of competition and sometimes the original creator is not in business in the end as rivals creep in and engage in a never-ending series of one-upmanship.

Advertising •

Advertising and packaging allow a firm to differentiate its product. Firms in monopolistic competition incur heavy advertising expenditures which make up a large portion of the price it charges for the product.

An Economics in Action case explores the cost of selling a pair of shoes. The vast majority of the costs are selling costs. .

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Selling costs, such as advertising, are fixed costs that increase the ATC at any given level of output but do not affect the MC. Advertising efforts are successful if they increase demand, which can lead to increased profit. But if all firms advertise, more firms might survive, and so the demand for any one firm is less than otherwise.

Using Advertising to Signal Quality •

Heavy marketing and advertising expenditures are a signal to consumers of a high-quality product.

A signal is an action taken by an informed person (or firm) to send a message to uninformed people.

Efficiency of Advertising and Brand Names •

Advertising and brand names might be efficient if they provide consumers with information about the precise nature of product differences and about product quality. So the final verdict about the efficiency of monopolistic competition is ambiguous.

An Economics in the News feature considers product differentiation in the market for smartphones. It studies how Apple successfully differentiates its phone and maintains a higher market share.

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Additional Problems 1.

The figure shows the situation facing Well Done, Inc., a producer of steak sauce. a. What quantity does Well Done produce? b. What does it charge? c. How much profit does Well Done make? d. If all steak sauce firms have identical cost curves and face identical demand curves, what happens to the number of firms in the market in the long run? e. In the long run, will the price of steak sauce rise, fall, or not change?

Solutions to Additional Problems 1.

a. b. c.

d. e.

To maximize profit, Well Done produces the quantity at which marginal revenue equals marginal cost. Well Done produces 200 bottles a week.

To maximize profit, Well Done charges the highest price that allows it to sell the 200 bottles of steak sauce it produces. This price is read from the demand curve and is $4 a bottle.

Economic profit equals total revenue minus total cost. The price is $4 and the quantity sold is 200 bottles, so total revenue is $800. Average total cost is $3, so total cost equals $600. Economic profit equals $800 minus $600, so Well Done makes an economic profit of $200 a week The firms are making an economic profit so new firms will enter the market. In the long run the number of firms is greater than in the short run.

In the long run the number of firms increases so that each firm’s demand is less than in the short run. With the lowered demand the price of steak sauce is lower in the long run.

Additional Discussion Questions 1.

In what sense is a firm in monopolistic competition similar to a monopoly firm?

Emphasize that each firm has some ability to raise market price through marketing effort and product differentiation. This means MR < P at all levels of output. In the long run, both markets are inefficient in the strict allocative efficient sense because: i) production does not occur at the lowest possible unit cost, and ii) P (=MSB) > MC (=MSC) at equilibrium, so each firm produces less output than is socially efficient.

2.

In what sense is a firm in monopolistic competition similar to a perfectly competitive firm? Emphasize that entry and exit affect the market price that each firm can charge in both markets. Also, low barriers to entry and exit make it impossible for any firm to enjoy economic profits in the long run.

3.

Is advertising real information or is it just hype? Have the class discuss whether an increase in the consumer’s willingness to pay for a product is sufficient to justify advertising

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as socially beneficial. There are only normative answers to this question, but it is still a useful exercise in carefully thinking about how we define efficiency in economic modeling.

4.

Imagine a four lane road in any suburban area in the country. Often there will be gas stations directly across the road from one another, rarely facing peak demand. Would it be more efficient to have just one gas station? If so, why do two survive over long periods of time? The situation of competing gas stations on opposite corners is a good example of excess capacity in monopolistic competition. Empty pumps and a less busy attendant mean gas costs a little more than otherwise; that is, the mark-up is positive. But consumers much prefer the convenience of pulling up to an open pump on the side of the road on which they are traveling rather than trying to cross multiple lanes of traffic to get in line for a gas pump with slightly cheaper gas which would more likely be the case if gasoline stations competed in a perfect competitive industry. Drivers find it worth paying a few cents more rather than having to maneuver across traffic and then wait available pump at a big busy station.

5.

What does it mean for a product to be differentiated? In papers and other assignments, I have had students argue that beer and soda were products that were “identical” or homogeneous rather than differentiated. It is worth having a discussion about what it means to be differentiated and the various methods firms can use to differentiate their products. Location, staffing and service, flavors, sizes, formulas, and even just packaging might differentiate products. As long as there is some difference between the goods or services, they might well be differentiated.

6.

Ford Motor Company today is taking market share from rivals and innovating new products with features consumers find desirable. But in the past, Ford famously lost market share to rivals when founder Henry Ford refused to engage in product differentiation, preferring instead the efficiency of mass production of a single product, saying that customers could get a Model T in any color, as long as it was black. What are the advantages and disadvantages of product differentiation? Can the market itself work out the right amount of product differentiation over time? If there are economies of scale, having fewer, larger amounts of production reduces cost. Differentiation adds costs, not just in formulas, but in packaging and other resources. If the differentiation is meaningful to consumers, then having various types of products and levels of quality and service adds meaningful value. To some degree, if a differentiation persists in the market, people must find it worth paying for. Consumers though must have good access to information and firms must be free to enter and exit as what the market wants changes over time.

7.

Are brands the same as companies? Does a crowded aisle at the store mean lots of competition? Most nationally distributed consumer products are created by firms in markets that are oligopolistic. The breakfast cereal aisle is crowded with all kinds of brands, but only 3-4 companies make most of the breakfast cereal sold nationwide. The toothpaste aisle is again crowded with varieties but the toothpaste market is dominated by just a couple of firms. Going back to the material in Chapter 10 about the differences between market structures and market concentration measures, now is a good time for an assignment or a discussion about the differences between brands and firms. Brand proliferation can be a sign of a lack of competition when students may interpret it as robust competition. This assignment or discussion can serve as a good bridge to discussing oligopoly.

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OLIGOPOLY

The Big Picture Where we have been: Chapter 10 began the study of the theory of the firm by describing various market structures and defining economic profit. Chapter 11 introduced various cost and production measures. Chapters 12, 13, and 14 presented perfect competition, monopoly, and monopolistic competition, respectively. Chapter 15 now wraps up the analysis of the firm’s output and price decision by examining oligopoly. The chapter examines various approaches to studying firm behavior in oligopoly and is the last of the chapters that focus on the theory of the firm.

Where we are going: Chapters 16 and 17 examine externalities, public goods, and common resources. Chapter 18 focuses on competitive factor markets. Chapter 19 investigates the distribution of income, the trends in the distribution, and some of the reasons for inequality and the trends. The final chapter, Chapter 20, analyzes some of the difficulties in making decisions when information is incomplete. None of the material in this chapter is used explicitly in the following chapters.

New in the Thirteenth Edition The chapter is little changed since the last edition. The final Economics in the News analysis has been changed to focus on a price war among cellphone service providers including the introduction of unlimited plans.

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Lecture Notes

Oligopoly •

Firms in oligopoly have only a few competitors. Their behavior can be analyzed using game theory, which shows the prisoners’ dilemma they can face.

The Economics in Action shows the Herfindahl-Hirschman Indices for 10 markets that are oligopolies. The text points out that the dividing line between oligopolistic and monopolistic competition is usually a HHI of 2,500.

I.

What is Oligopoly?

The distinguishing features of an oligopoly are the presence of natural or legal barriers that prevent the entry of new firms and so only a small number of firms compete.

Barriers to Entry • •

A natural oligopoly market occurs when the efficient scale of production allows only a few firms to meet the market demand.

A legal oligopoly arises when a legal barrier to entry protects the small number of firms in the market.

Small Number of Firms • • •

Because of entry barriers, the number of firms is small and each has a large share of the market.

Because there are a small number of firms, the firms in an oligopoly market are interdependent— each firm’s profit depends on its actions and the actions of its competitors.

The firms have a temptation to form a cartel, which is a group of firms acting together— colluding—to limit output, raise price, and increase economic profit. Such collusion is illegal in the United States but it still occurs.

II. Oligopoly Games •

Economists think of oligopoly as a game between just a few players and use game theory to study oligopolistic behavior.

Game theory is a tool for studying strategic behavior—behavior that takes into account the expected behavior of others and the recognition of mutual interdependence.

What is a Game?

•

• Games have rules, strategies, payoffs, and outcomes.

The Prisoner’s Dilemma captures many of the essential features of games and gives a good illustration of how game theory works and generates predictions.

Game theory is an entirely different approach to modeling a firm’s output and price decisions. It allows for the expected actions of all other firms in the market to be explicitly considered in the firm’s decisionmaking process. Game theory is a big step for the student and need a significant amount of time to develop.

This chapter is designed to be flexible and provide you with many options on just how far to go.

1. You might want to introduce only the prisoner’s dilemma game.

2. You might want to spend serious time applying the prisoner’s dilemma to a cartel game.

3. You might want to extend the range of examples and apply the prisoner’s dilemma to a real-world research and development game.

4. Finally, you might want to introduce repeated and sequential games and some of their applications and implications.

Each of the steps laid out above is optional, but cumulative. You can stop at any point, but shouldn’t try to skip a step except that you can teach the R&D game based on the general introduction to the prisoner’s dilemma without teaching the longer and more complex cartel game. .

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The Prisoners’ Dilemma • • • • •

•

In the prisoner’s dilemma, the rules specify that each prisoner is placed in a separate room and must choose whether to confess without conferring with his accomplice.

Strategies are all the possible actions of each player.

The game’s payoff matrix, a table that shows the payoffs for every possible action by each player for every possible action by each other player, is to the right. In it are the payoffs from each prisoner’s strategies, which are to confess or deny involvement in the serious crime.

The choices of both players determine the outcome of the game. We use the concept of a Nash equilibrium to predict the outcome of a game.

Art (A) and Bob (B) have been caught A’s strategies stealing cars. Both men are sentenced to Deny Confess two years in jail for this crime. Both are suspected of committing a more serious 10 years 3 years crime for which the prosecutor has Confess insufficient evidence for a conviction. The 3 years 1 year two men are each interrogated for the B’s more serious crime in separate cells. Each strategies prisoner is told that if he confesses and his 2 years 1 year partner denies, he will serve 1 year in jail Deny and his partner will serve 10 years, while 10 years 2 years if both confess, both serve 3 years. If neither confesses, each man will spend 2 years in jail, after being convicted of a lesser crime. These “payoffs” are in the payoff matrix.

In the Nash equilibrium of the prisoner’s dilemma game, player A takes the best possible action given the action of player B and player B takes the best possible action given the action of player A. The Nash equilibrium for the prisoners’ dilemma is for both players to confess. This outcome is bad for them because both would be better off if each denied.

• A dominant strategy is a strategy is better than another for one player, regardless of how the other players play. In the prisoners’ dilemma, each player has a dominant strategy of “Confess.”

An Oligopoly Price-Fixing Game •

• •

Firms in an oligopoly can face a prisoners’ dilemma game. Suppose there are two firms, A and B. The firms could enter into a collusive agreement to jointly boost their price and decrease their output. Once the agreement is made, each firm must select its strategy: cheat on the agreement or comply with the agreement.

The payoff matrix is to the right. Each A’s strategies firm’s profit depends on its strategy and Comply Cheat that of its competitor.

The Nash equilibrium for the game is −$1 million $0 for both firms to cheat on the Cheat agreement. The outcome is bad for them because both would be better off B’s $0 $5 million if each complied with the agreement. strategies This Nash equilibrium is called a $3 million $5 million dominant strategy equilibrium, which Comply is an equilibrium in which the best strategy of each player is to cheat $3 million −$1 million .

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regardless of the strategy of the other player.

The Economics in Action considers R&D spending in the facial tissue market, with Proctor & Gamble producing Puffs and Kimberly Clark, Kleenex. In this game both firms spend for R&D, which is less profitable for both than if they could collude and do no research. Rivalry forces them to be innovative. This case reminds students that firms do R&D to sell products rather than for higher moral purposes.

A Game of Chicken •

• •

In an R&D game of chicken, two firms, A and B, can conduct R&D. The firm that conducts the R&D must pay for the R&D, but the R&D will lead to a new product that both firms can produce.

Each firm’s strategies are to conduct the R&D or not conduct the R&D. The payoff matrix for this game is to the right This game does not have a Nash equilibrium that is a dominant strategy equilibrium. Here the equilibrium is for one firm to conduct the R&D but we cannot predict which firm will conduct it.

A’s strategies R&D No R&D $2 million

$3 million

R&D B’s strategies

$2 million $1 million

$1 million $0 million

No R&D $3 million

$0 million

Examples of oligopoly to discuss: Gillette and Schick compete aggressively to capture the market for men’s razors; AMD and Intel do likewise for the CPU market. These products are made by dominant consumer products corporations that spend significant resources on research and development and advertising to develop brand loyalty. Discuss the entry barriers a firm considering going into these markets might face and why they are likely to remain dominated by just a couple of key firms. Ask your students to apply this analysis to another oligopolistic market and to identify the entry barriers and ways firms engage in both price and non-price competition.

III. Repeated Games and Sequential Games

Many more potential outcomes are possible if players repeatedly play games. Players also can often wait until a rival has made a move before choosing a response.

A Repeated Duopoly Game •

If a game is played repeatedly, it is possible for players of the game to reach the cooperative equilibrium in which the players make and share the monopoly profit. Because the game is played repeatedly, a player can use a tit-for-tat strategy, in which the player cooperates in the current period if the other player cooperated in the previous period, but cheats in the current period if the other player cheated in the previous period.

Economics in the News Airbus versus Boeing considers the plane makers’ rivalry in producing passenger jets and their decisions whether to discount or charge list price.

• A tit-for-tat strategy used with the payoff matrix at the top of the page leads to the cooperative equilibrium.

Are there any real-world cooperative equilibria? The OPEC oil cartel is an excellent example of how useful game theory can be to explain real world events. Use the prisoner’s dilemma game to illustrate the incentive each nation faces: whether to cheat on their agreement or comply with it. A tit-for-tat strategy makes all the nations (as a group) better off but the demand for oil fluctuates and it is difficult for each .

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nation to determine whether the other nations are cheating on the agreement. This combination makes a cartel agreement difficult to monitor, which is why we see the price of oil fluctuate so much, even during peaceful times. Saudi Arabia is widely believed to be the market leader for the cartel. Its oil output decisions have waxed and waned significantly over time, so oil prices fall when its government needs the extra oil revenues (cheating) or rises when the political environment requires greater economic unity among the Arab nations (cooperating).

A Sequential Entry Game in a Contestable Market • •

A contestable market is a market in which firms can enter and leave so easily that those firms in the market face competition from potential entrants.

Firms in a contestable market play a sequential entry game. In this game, the firms in the market might set a competitive price and earn only a normal profit to keep the potential entrant out. A less costly strategy is limit pricing, which sets the price at the highest level that inflicts a loss on the entrant. The potential entrant is kept out and the existing firms earn an economic profit. However, limit pricing works only if the firm that sets the price is somehow locked into the price it will set at the second stage of the game.

How does a game tree work? The textbook uses the simplest possible example to illustrate the sequential entry game in a contestable market. It doesn’t explicitly explain the “backward induction” method of solving such a game, but it implicitly uses that method. If you choose to spend more time on sequential entry examples, you might want to be more explicit.

IV. Antitrust Law • •

Antitrust law is the law that regulates oligopolies and prevents them from becoming monopolies or behaving like monopolies.

The two federal agencies that enforce antitrust laws are the Federal Trade Commission and the Antitrust Division of the U.S. Justice Department.

The Antitrust Laws • •

The Sherman Act (1890) made it a felony to create or attempt to monopolize an industry. Section I declares it illegal to conspire with others to restrict competition. Section II deems any attempt to monopolize illegal.

The Clayton Act (1914) makes illegal certain business practices if they “substantially lessen competition or tends to create a monopoly.” These practices include price discrimination, typing arrangements, requirements contracts, exclusive dealing, territorial confinement, acquiring a competitor’s shares or assets, or becoming a director of a competing firm. If these actions do not substantially lessen competition and do not tend to create a monopoly, the actions are legal.

Price Fixing by Competitors Always Illegal • •

Price fixing by competitors is per se illegal, which means it is always illegal. There is no defense that can justify the practice.

By restricting production, a price-fixing cartel raises the price to the monopoly level. Consumers suffer and deadweight losses are created.

Three Antitrust Policy Debates •

Resale Price Maintenance: Resale price maintenance (also called vertical price fixing) occurs when a distributor agrees with a manufacturer to resell a product at or above a specified minimum price. Resale price maintenance is illegal only when it is judged to be anticompetitive. Whether resale price maintenance creates an inefficient or efficient use of resources is debated. It is efficient when it induces retailers to provide the efficient level of service to customers (e.g., be financially able to explain to potential consumers the benefits of a particular good). .

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Tying Arrangements: A tying arrangement is an agreement to sell one product only if the buyer agrees to buy another, different product. These bundling arrangements may enable a firm to price discriminate, resulting in an increase in efficiency.

Predatory Pricing: Predatory pricing is setting a low price to drive competitors out of business with the intention of setting a monopoly price when the competition has gone. Economists are skeptical that predatory pricing occurs.

An Economics in Action case considers the U.S. versus Microsoft antitrust case, including the charges, Microsoft’s response and the outcome. Students may want to consider how Microsoft’s market power has changed in the last decade. Is it a result of government intervention? Or is it a result of competition as Apple has gained increasing market share in operating systems as its sales have grown?

Mergers and Acquisitions • •

A merger occurs when two or more firms agree to combine to create one larger firm. Acquisitions occur when one firm buys another firm.

FTC guidelines stipulate that a HHI above 1,800 indicates a concentrated market, and a merger in this market that would increase the index by 50 points is likely to be challenged.

The Economics in Action feature describes how the FTC used its HHI guidelines to block the proposed AT&T acquisition of T Mobile.

The Economics in the News feature again examines price wars in the cell phone service provider market but now focuses on the competition for unlimited service plans.

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Additional Problems 1.

Two firms, Faster and Quicker, are the only two producers of sports cars on an island that has no contact with the outside world. The firms collude and agree to share the market equally. If neither firm cheats on the agreement, each firm makes $3 million economic profit. If either firm cheats, the cheater can increase its economic profit to $4.5 million, while the firm that abides by the agreement incurs an economic loss of $1 million. Neither firm has any way of policing the actions of the other. a. What is the payoff matrix of a game that is played just once? b. Describe the best strategy for each firm in a game that is played once. c. What is the equilibrium if the game is played once?

Solutions to Additional Problems 1.

a.

b.

c.

The payoff matrix has the following cells: Both abide by the agreement: Faster makes $3 million profit, and Quicker makes $3 million profit; both cheat: Faster makes $0 profit, and Quicker makes $0 profit; Faster cheats and Quicker abides by the agreement: Faster makes $4.5 million profit, and Quicker incurs a $1 million loss; Quicker cheats and Faster abides by the agreement: Quicker makes $4.5 million profit, and Faster incurs $1 million loss.

The best strategy for each firm is to cheat. If Quicker abides by the agreement, the best strategy for Faster is to cheat because it would make a profit of $4.5 million rather than $3 million. If Quicker cheats, the best strategy for Faster is to cheat because it would make a profit of $0 (the competitive outcome) rather than incur a loss of $1 million. So Faster’s best strategy is to cheat, no matter what Quicker does. Repeat the exercise for Quicker. Quicker’s best strategy is to cheat, no matter what Faster does.

The equilibrium is that both firms cheat and each makes normal profit.

Additional Discussion Questions 1.

Could you manage a successful cartel? Emphasize the fragility of cartel arrangements by using the following numerical example. Point out that if a cartel is to operate successfully, all the firms must behave collectively as a monopoly, producing market output where MR = MC and charging the resulting profit-maximizing price. Because there are multiple firms in a cartel, and each firm is likely to have different production cost functions, then this raises two critical issues: • How should production quotas be allocated across firms to minimize total production costs and maximize potential profits?

MC for MC for MC for • How should the profit quotas be Quantity Firm A Firm B Firm C allocated across firms to maintain 1 2 1 2 compliance?

2 1 2 3 Start by assuming there are 3 firms in the cartel with the marginal cost schedules in 3 2 3 4 the table. Also assume that the profit4 3 4 5 maximizing level of output for a monopoly 5 4 5 6 would occur at 9 units per period, where MR = $3. Finally assume that there are no fixed costs. Now, if you were the leader for the cartel, how would you propose the production quotas be allocated to minimize production costs and maximize profits to share? .

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3.

Based on minimizing variable costs, and knowing that MR = $3 at 9 units of output, Firm A should produce 4 units, Firm B should produce 3 units and Firm C should produce at 2 units per period. Total output is 9 units, MC = $3 for all three firms, and the total cost of industry production is: $8 for Firm A, $6 for firm B, and $5 for firm C for a total cost of $19 per period.

How should the profit quotas be distributed across the firms? Ask the students to consider allocating profits according to each firm’s share of total production costs. Firm A would receive 8/19 of the profits, firm B would receive 6/19 and firm C would receive 5/19 of the profits. Most students will accept this as a “fair” allocation of profits for the firms. But this agreement will not work for long.

Will the cartel survive using this profit quota arrangement? Point out that what keeps each firm in compliance with the agreement is not an independent assessment of “fairness” for the ultimate profit distribution. The profit quota agreement must be worthwhile to each and every firm in the cartel. Emphasize that the profit from complying must exceed the profit from cheating for each firm if the cartel agreement is to be successful in the long run.

What is the opportunity cost for complying for each firm? Point out that based on Firm C’s cost function, the prospect of its competing with the other firms is rather grim. But Firm A’s cost function implies that it would not fear the threat of competition from the other firms because A’s marginal cost is lower than each of its two (potential) competitors.

Because A does not fear cheating, it will have the upper hand in determining profit quotas for the cartel. Clearly Firm A will want as much profit as it can have from each of the other firms without making their profit from cheating exceed their profit from complying. That is the only profit sharing arrangement that will allow the cartel to survive over time. What, then, is the long-run profit-sharing agreement? The answer depends on the demand for the good or service as well as the strategies played by each firm. For instance if the demand is inelastic but low, so that if Firm A increased its output by 1 unit the price would fall so precipitously that Firm C suffered an economic loss, then even though the 4th unit would not be directly profitable for Firm A to produce, the threat of so doing might allow Firm A to grab some of Firm C’s “fair share” of profit.

What industries are dominated by cartels? OPEC isn’t the only example of a cartel. Ask students what they think of when they hear the word “cartel,” and a common response is “drug cartel.” Like the cartels studied in this chapter, members of a drug cartel agree upon the price at which their merchandise can be sold. Cooperation can be maintained through a repeated game where a system of punishments is incorporated. Consider the punishments members of a drug cartel can impose for violating an agreed-upon price rule. It probably isn’t much of a surprise that cooperation among drug cartel members can be maintained when the consequences of cheating on any agreement include death or the slow and painful removal of one’s fingernails.

Another example of a cartel that students won’t be as likely to suggest is the NCAA. The NCAA is an example of a buyer’s cartel, as opposed to a seller’s cartel, but the results are similar. Schools that are members of the NCAA have agreed not to pay their student athletes a salary, effectively “fixing” the price paid for student athletes. Cooperation is maintained through a system of punishments for violations of NCAA rules. The incentive to cheat on those agreements still exists, as the number of NCAA violations attests.

Has Microsoft attempted to create a monopoly? Whether Microsoft is a monopoly depends on the market being defined. Many of your students will have their own opinions, but use the “Antitrust Showcase” in the text is a starting point for discussion. The issue of having a standard to create programs and products around continues to be debated as .

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programming for Apple’s applications for the iPhone differ from standards used by other firms, and as Apple rejected flash technology offered by Adobe and widely used in other applications.

Can firms create entry barriers? Students often have a difficult time identifying entry barriers. Some come from economies of scale, some from government activity, and some the firms create. Consider the barriers in the airline industry or cell phone services. Gates and landing slots may come from government activity. Economies of scale certainly exist. But firms also work hard to differentiate their products and try to capture market share through strategic barriers such as AT&T’s initially exclusive ability to offer the iPhone.

Students have little knowledge of distribution generally so using specific examples from different types of industries can broaden their knowledge.

If predatory pricing is generally not regarded as a problem by economists and antitrust enforcers, why is dumping such a big deal? Again as suggested in the lecture notes, this is a good place to reinforce the trade theory discussed in chapter 7. Prior to the Uruguay Round, voluntary export restraints were widely used (and abused) as a way around agreements to reduce trade barriers. Their use was restricted by that agreement. Since then, dumping cases have exploded at the same time predatory pricing cases are largely no longer pursued. Searching the World Trade Organization web site will yield many examples of dumping cases. Alleging dumping can be as simple as saying the product is being sold at a lower price than a domestic firm can match, which is often the definition of a product likely to be imported. Do low prices hurt consumers? Consumer surplus and producer surplus can be used to reinforce the prior examples.

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PUBLIC CHOICES, PUBLIC GOODS, AND HEALTHCARE

The Big Picture Where we have been: A parallel is drawn between the equilibrium in markets, introduced in Chapter 3, and the concept of equilibrium in a political marketplace. The concept of efficiency, introduced in Chapter 2 and elaborated upon in Chapter 5, is used in this chapter to assess market failure.

The definitions of marginal social benefit, marginal social cost, and deadweight loss are used explore the provision of public goods and mixed goods that have external benefits.

Where we are going: Chapter 17 continues the analysis by studying the inefficiencies that result when private markets produce mixed goods with external costs and allocate common resources. It also considers methods that can be used to fix the misallocation. Chapters 18 and 19 cover the labor and other resource markets and the resulting distribution of income. Redistribution of income is addressed as a possible role for government in this chapter. Chapter 20 discusses risk and uncertainty.

New in the Thirteenth Edition In this edition, the focus and analysis of health care issues has been updated and expanded.

Applications have also been updated. A new Worked Problem section has been added. The Worked Problem presents data on the marginal social cost of mosquito spraying and three consumers’ marginal benefit from the spraying. It then shows the students how to calculate the (total) marginal social benefit curve and the efficient quantity of spraying. To include the new Worked Problem without lengthening the chapter, some problems have been removed from the Study Plan Problem and Applications. These problems are in the MyEconLab and are called Extra Problems.

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Lecture Notes

Public Choices, Public Goods, and Healthcare I.

Public choices • • •

A private choice is a decision that has consequences only for the person making it.

A public choice is a decision that has consequences for many people and perhaps the entire society.

Decisions by political leaders and senior public servants might improve efficiency, but, as was observed in prior chapters, these choices might also make things worse and lead to deadweight losses.

Why Governments Exist • • • • •

Governments establish and maintain property rights, provide nonmarket mechanisms for allocating scarce resources, and implement arrangements that redistribute income and wealth.

Markets rely on property rights to function.

Choices made pursuing self interest may not always be in the social interest and governments may reallocate resources.

The market economy delivers a distribution of income and wealth that many people regard as unfair, so equity requires some redistribution.

Government failure occurs when government action leads to inefficiency, which could be underprovision or overprovision of resources to a given activity.

Public Choice and the Political Marketplace • • • • •

The political marketplace is made up of many individuals each with their own economic objectives.

Four groups of decision makers—voters, firms, politicians and bureaucrats—interact in the political marketplace.

In the economic model of public choice, voters support the politicians whose policy proposals make the voter better off. Voters express their demand for policies by voting, helping in campaigns, lobbying, and making political contributions.

In the economic model of public choice, firms also support the politicians who policy proposals make them better off and express their demand for public goods and services, but firms can’t vote.

They do make political contributions and engage in lobbying activities.

Politicians are elected persons at all levels of government. They make the policies that bureaucrats carry out. Politicians’ goals are to gain election and reelection, so voters to a politician are like profits to a firm.

Bureaucrats are public servants who work in government departments. Their self interest is best served by larger budgets, which bring more authority and prestige.

Political Equilibrium • • •

All four groups make choices that are in their own self interest and are constrained by what is feasible.

In a political equilibrium, the choices of all four groups are compatible and no group can see a way of improving its position by making a different choice.

Allocative efficiency in the use of resources is possible but is not guaranteed.

The political marketplace does not work as smoothly as the private marketplace. Throughout this text students have learned that competitive markets can deliver an efficient resource allocation: • Individuals and firms act in their own self-interest, but in the private market (in the absence of externalities) individuals receive the full benefits of making good decisions with their resources, and bear the full costs of making poor decisions with their resources. Market prices and profits send .

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signals to consumers and producers that coordinate their decisions. In the absence of price floors, price ceilings, quotas, monopoly, and taxes, the competitive pressures of the market determine an equilibrium price where the marginal social benefit is equal to marginal social cost, and the outcome is efficient.

However, the political marketplace does not possess the same power as the competitive market to convert self-interest into an efficient outcome: • Individuals still act in their self-interest. As James Buchanan, the Nobel Prize winning economist, once noted, when we pull the curtain closed in the voting booth to indicate which representative we wish to elect, we do not suddenly sprout the wings of angels and vote in the public interest. We vote our own best interests, possibly to the detriment of the public interest. But one person, one vote does not ensure equal political influence over the resource allocation process. Some avenues to seek favor from politicians and bureaucrats require resources, which are unequally distributed. Individuals no longer receive the full benefits nor bear the full costs of their decisions over publicly provided resources, and so individuals are less motivated to act on the basis of complete information. The absence of price and profit signals and incentives to make wise decisions with publicly provided resources makes it difficult to coordinate the decisions of self-interested individuals to generate socially beneficial outcomes. Many political marketplace decisions over public goods provisions are inseparable, bundled together as a package, which decreases the competitive pressures that force individuals to respond to opportunity cost and marginal benefit.

What is a Public Good?

Goods, services, and resources can be classified along several dimensions: • Excludability: A good or service is excludable if only the people who pay for it are able to enjoy its benefits. An automobile or watching an NFL game in person would be excludable. A good or service is nonexcludable if everyone benefits from it regardless of whether they pay for it. National defense or a town’s Fourth of July fireworks display are nonexcludable.

• Rivalry: A good, service, or resource is rival if its use by one person decreases the quantity available for someone else. A blouse or a slice of pizza is rival. A good, service, or resource is nonrival if its use by one person does not decrease the quantity available for someone else.

Watching television or national defense is nonrival.

Examples: The more examples you give of each classification, the easier this topic will be for your students. Be sure to identify each characteristic for a given good. For example, a candy bar is a private good. It is excludable because, if you purchased it, you can decide who gets it. It is also rival because, once you eat it, there is less available for anyone else. Sunshine, on the other hand, is a public good. It is nonexcludable because you can’t determine who gets to use the sun and who can’t. It is nonrival because your use of the sun does not diminish the amount of sun available for anyone else. Ask your students to think of other goods and resources and evaluate each on the basis of these characteristics. More examples are included in the “Additional Discussion Questions” section.

Is a highway a public good or a private good? Interstate highways are generally public goods. They are nonexcludable because anyone is permitted to drive on the interstate. When they are not congested, they are also nonrival because adding one more car to the interstate has little to no impact on the ability of other drivers to continue using the highway. However, interstate highways that charge a toll become excludable. And many interstates become rival goods during rush hour. If a highway charges a toll and is often jammed with traffic, it is actually a private good.

A Fourfold Classification

Based on these differences, goods, services, or resources can be classified into one of four categories: • A private good is both rival and excludable. A cow owned by a dairy farmer is a private good. .

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A public good is both nonrival and nonexcludable. National defense is a public good.

A common resource is rival and nonexcludable. Fish in the ocean are a common resource.

A natural monopoly is nonrival and excludable. Cable television is a natural monopoly.

Is every publicly provided good a “public good”? Students often think that, by definition, everything provided by the government is a public good. This belief is false. Point out to them that many government services are neither nonrival nor nonexcludable: Electricity provided by the TVA and many local governments, satellite launching services, and food stamps are three quick examples. Food stamps are provided as a means of redistribution. But for the goods and services that are rival and excludable (electricity and satellites) the private market ought to be able to provide the efficient allocation without government provision.

Healthcare •

Healthcare is actually two goods: Care supplied by doctors and other professionals and insurance.

II. Providing Public Goods The Free-Rider Problem • •

A public good creates a free-rider problem—the absence of an incentive for people to pay for what they consume.

The free rider problem leads private markets to produce an inefficiently small quantity of a public good; that is, the private market underproduces a public good. The marginal social benefit from the public good exceeds the marginal social cost and a deadweight loss arises.

Are you a free rider? Ask your students what they think would happen if Starbucks set up a serveyourself coffee bar in the student union. No one would work the counter, and charges would be collected on the honor system. How many of your students would actually pay for coffee in that case?

What free-rider problems do your students deal with on a daily basis?

• In some classes the students are assigned to a group for completing a graded project, where the grade earned on the project is shared by each group member. Sharing the grade means that there are insufficient incentives for each group member to provide the level of effort that would achieve the highest potential grade for the group.

• Waiting tables is a common part-time job for many students. Many restaurants make the wait staff share their tips with the other wait staff and busboys that clear the tables. Under this system, there are insufficient incentives for the busboys and less-motivated wait staff to provide the level of service that maximizes tipping from diners.

• Public restrooms are generally recognized as being far less clean than the vast majority of users would like, especially compared to their own private bathrooms. There are insufficient incentives for each user of a public bathroom to keep it clean enough to appease most users.

Marginal Social Benefit from a Public Good •

Public goods have a marginal social benefit that differs from the marginal social benefit for a private good. Because everyone can consume services from the same unit of a public good, the marginal social benefit of a public good is the maximum amount that all the people are willing to pay for one more unit. The economy’s marginal social benefit curve for a public good is obtained by vertically summing each individual’s marginal benefit curve.

What is “vertical” vs. “horizontal” summation? Whether we add marginal benefit curves together vertically or horizontally is sometimes a source of confusion for students. Tell them to focus on the unit of measurement on each axis. When we are looking at private goods, we want to know how many units .

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should be produced to satisfy market demand at a given price. Because private goods are both rival and excludable, each buyer must have his or her own units, so we must add together the number of units demanded by each individual. In other words, we’re adding the horizontal coordinates (quantities) of individual demand curves to get the market demand curve, and we say we are adding the individual demand curves or marginal benefit curves “horizontally.” For public goods that are nonrival and nonexcludable, anyone who purchases a good is providing that good to everyone. If every consumer in the market demands one unit of a good, we can’t simply add together all of those units. Once one unit is provided to anyone, it is provided to everyone. The benefit of that unit will be determined by the sum of individual marginal benefits for that unit. An individual’s marginal benefit is measured as the y coordinate of an individual demand curve, so to find the marginal social benefit, we add all of the individual marginal benefits together. We say we are adding the individual demand curves or marginal benefit curves “vertically.”

Marginal Social Cost of a Public Good •

The marginal social cost of a public good is determined the same way as that of a private good.

Efficient Quantity of a Public Good •

The efficient quantity of a public good is the quantity that sets the marginal social benefit equal to the marginal social cost. At this quantity, society’s net benefit from the public good is maximized.

Inefficient Private Provision •

A private market will produce an inefficient quantity of a public good because of the free rider problem. Consumers free ride by choosing not to pay for the public good, and instead use the funds to purchase private goods.

Efficient Public Provision • •

Competition in the political marketplace can result in the efficient provision of public goods.

The Principle of Minimum Differentiation is the tendency for competitors (including political parties) to make themselves similar in order to appeal to the maximum number of customers.

Consequently political parties tend to have similar policies in order to appeal to the maximum number of voters.

• For the political process to deliver efficient outcomes in providing public goods, voters must be well informed, evaluate the alternatives, and vote in the election. Political parties must be well informed about voter preferences.

The Economics in Action feature considers the case of providing fire protection to extinguish the 2012 Colorado wild fires. While fire protection is provided by the government, it is often produced by private companies.

Inefficient Public Overprovision •

Bureaucrats translate the choices of politicians into programs, and control the day-to-day activities that deliver public goods. Bureaucrats may have other ideas and frustrate rather than facilitate the efficient outcome. By expanding the size and scope of their programs, bureaucrats gain more power, potentially greater management authority, and more lucrative compensation. Bureaucratic actions may lead to government failure.

•

Rational ignorance is the decision not to acquire information because the cost of doing so exceeds the expected benefit. Each voter is likely to be rationally ignorant about the efficient quantity of a public good. Rational ignorance, combined with special interest groups and bureaucrats seeking larger quantities of public goods, might lead voters to support political policies that generate inefficiently high levels of public goods.

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Do politicians and bureaucrats make choices the same way voters do? Economists are comfortable with the assumption that, in their private lives, individuals make choices based on their own self-interest.

As a result, many economists believe that the same assumption should be made about voters, politicians, and bureaucrats. If these groups make choices in their own self-interest, the assumptions of the public choice theory are upheld: voters will be rationally ignorant, bureaucrats will seek to increase the scale of their programs, and politicians will propose more than the efficient quantity of public goods.

III. The Economics of Health Care Health Care Market Failure • •

The market for health care consists of health care services and health insurance.

Consumers underestimate the benefits of health care, underestimate their own future needs, and can’t afford the care they need, so the marginal social benefit exceeds the private willingness to pay for it. Consequently a private health care markets underproduces health care.

•

•

•

•

The figure shows the market demand curve or perceived marginal benefit curve (MB) and the marginal social benefit curve (MSB) for health care.

The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, where MSB = MSC. In the figure, the efficient quantity is Q1.

An unregulated market, however, produces where S = D. In the figure, the unregulated market equilibrium is Q0. At this level of output, MSB exceeds MSC so there is a deadweight loss, as illustrated in the figure.

This loss is unevenly spread across consumers leading to unfairness. Healthy, higher income earners can afford care. The long-term sick, the aged, and the poor can’t afford care and thus bear most of the deadweight loss.

Alternative Public Choice Solutions • •

•

Across nations, there is a wide range of public funding for health care. The text examines three approaches to supplementing or replacing the private market for health care: universal coverage, single payer; private and government insurance; and, subsidized private insurance.

Universal Coverage, Single Payer • The model in the United Kingdom and Canada: is universal coverage with a single payer. The government is the sole buyer and everyone is covered. People access services a zero (or a low) price and the quantity available is set by the government, leading to excess demand. Services are allocated on a first-come, first-served basis, resulting in long delays for treatment. The quantity made available by the government is less than the efficient quantity, so a deadweight loss results.

Private and Government Insurance • In the United States, most health care is provided privately and paid for by private health insurance, government, and patients. It is difficult to determine if healthcare is overprovided given the different payment types, but the scale of healthcare spending in the United States compared to other rich countries suggests it may be. Over provision leads to deadweight losses. Government spending on health care is dependent on the quantity of care demanded, .

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not on a set budget. Without changes, an aging population will significantly increase this spending in the future.

The Economics in Action case breaks down the sources of payment for health care in the United States.

•

Subsidized Private Insurance • Obamacare, or the Patient Protection and Affordable Care Act, uses a subsidized insurance market. To determine whether the outcome of the subsidy is efficient, we need to know the extent to which the marginal benefit of health insurance actually exceeds a household’s ability to pay.

The At Issue feature considers whether Obamacare is the answer to U.S. health care provision problems.

Vouchers a Better Solution?

•

When marginal social benefits exceed the ability and willingness to pay, economists suggest vouchers can be used to attain efficiency. A voucher is a token that can be used to buy only the specified item.

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A voucher program could replace most government health programs. The total value of vouchers would be set by government, but households would decide how to allocate healthcare spending.

•

The markets for health care services and health insurance would be free to work similarly to other competitive markets, which allocate resources efficiently.

An Economics in Action case considers the challenge of maintaining the U.S. transportation infrastructure given the decrease in gasoline taxes, which is the primary revenue source used to maintain the infrastructure. The analysis shows how the outcome might be an inefficient quantity of infrastructure being provided.

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Additional Discussion Questions 1. How “public” are government goods and services? Challenge your students to name public services provided by the government. In case the students miss them, mention the following services: • Postal Services: This is somewhat nonrival, in that the postman is walking by everyone’s house anyway, but definitely excludable—no stamp, no delivery. It is a natural monopoly rather than a public good.

• Education: This is also somewhat nonrival, in that increased human capital benefits more than just the student. However, the private sector education industry is growing rather than shrinking over time, indicating that the private benefits are large compared to the public benefits. Also, it is excludable, meaning that it is not a public good.

• Passenger Rail Service like Amtrak: Rail service is nonrival when the trains are not crowded because, in that case, one individual’s use of rail service doesn’t preclude others from also using the service. When the train is at its maximum carrying capacity, however, rail service is then rival because adding an additional consumer requires that another consumer be bumped. Train service is definitely excludable. As such, when the trains are not crowded it would fall into the category of natural monopoly, and when they are crowded they would be a public good.

• National Parks and Forests: Given the vast size of our national parks and forests, use by one individual has little impact on the level of benefit others receive from using the same services. However, parks and forests that are overused and trashed become rival.

Most national parks are excludable. Fees are charged for camping in them, for example.

However, the large area covered by national parks and forests makes it more difficult to exclude others from using the parks and forests, even if fees aren’t paid, making them somewhat nonexcludable. National parks and forests may be public, private, common resources, or natural monopolies, depending on the extent of rivalry and excludability.

2.

Will resource allocation be efficient when the price mechanism is absent in the provision of public goods and services? Emphasize that when political equilibrium conditions separate the people who consume the services from the people who pay for the services, the valuable price signal is lost. Those that consume the good do not take into account the opportunity cost of consuming that good or service when making their own resource allocation decisions. Examples: Why are private schools and home schooling so prevalent when all children in the United States (even the children of illegal immigrants) are provided with free education? The student and his or her family receive the benefits of increased human capital but pay only a portion of the cost of providing it. The median voter is reluctant to support higher taxes for educational programs and rational ignorance implies that he or she is also unlikely to be motivated to see whether the existing funds are being utilized efficiently. This results in government delivering relatively poor public educational services.

Also point out that the parents of children attending private school, or the parents who use their own labor to teach their children at home, all still pay local taxes to support public education. This implies that the high opportunity cost of consuming private education is still less than the perceived opportunity cost of sending their children to public schools.

Why are private security companies so prevalent when each city has a legitimate, professional police force? The greatest benefactors of police protective services are usually those citizens living in the poorest neighborhoods with the lowest incomes. The median voter’s income level isn’t so far away from the average income voter that the level of protective service that he or she receives is above average. This means the median voter .

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does not support a level of protective services that could effectively deal with the high crime areas as well as the less frequent incidence of crime that occurs in average or above average income neighborhoods.

3.

Is government regulation better than an inefficient market result? The simple answer is “not necessarily.” Stress that when market failure brings pleas for political processes to replace the market process for resource allocation, it should be shown that the inefficiencies created by the market failure are greater than the inefficiencies inherent in the proposed political allocation process. Point out that when politicians and bureaucrats propose public sector policies to replace market allocation processes, they rarely discuss whether their policy prescriptions would pass such an analysis. Emphasize that when it comes to moving resource allocation decisions out of the private market and into the realm of political markets, there is still an opportunity cost to be weighed against the perceived benefits: there is no such thing as a free lunch!

4.

Are you a free-rider in your school’s computer lab? Many colleges and universities have run into problems with the amount of printing that occurs on their campuses. The more students print, the more paper expenses rise, and the more frequent repairs and maintenance will be for printers at the school. If a school does not charge students for printing in the computer labs, what incentive is there to minimize printing? While this may be an expense that is “included” in tuition and fees, because that cost is spread across all students, no single student bears the entire cost of his or her printing. As more books become available online as e-books, this problem has become more difficult to handle.

Because e-books are typically cheaper than traditional paper books, many students simply buy the e-book and then print the entire book in the school computer lab, effectively pushing the cost of the book onto the school. To alleviate some of this free-rider problem, many schools have begun to charge their students for printing, or they have predetermined limits set on the number of pages students are allowed to print.

5.

Does a democratic process ensure an efficient outcome? Many political science classes tout that democratic politics is the “art of compromise,” implying that the compromise solutions to conflicting objectives that are inherent in democratic decision processes necessarily generate efficient outcomes. The example in the table below illustrates why a democratic vote can fail to ensure the economic definition of efficiency.

• If tax policy proposal A (a levy supporting education) were presented by itself, it would fail to receive support from the majority of voters.

•

Likewise, if tax policy proposal B (a levy supporting the police force) were presented by itself, it would also fail to gain support from the majority of voters.

•

Yet, the politicians sponsoring each bill can act cooperatively and present an omnibus bill combining both policy proposals. This is known as logrolling—trading political favors to pass separate bills that would otherwise fail to achieve majority support on their own.

•

The majority of voters will support the omnibus bill, despite the fact that net benefits for all society would be higher if the omnibus bill had not passed.

Policy Proposal A: Education

Policy Valuation

by Voter A

Policy Valuation

by Voter B

Policy Valuation

by Voter C

+$150

-$100

-$100

.

Does Vote Pass?

Net Social Benefits No: (1-2) -$50

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6.

B: Police

-$100

+$150

-$100

Policy A + B

+$50

+$50

-$200

No: (1-2) -$50 Yes: (2-1) -$100

Snow and road plowing—when is it a public good versus a private good? If you teach in a part of the country that gets snow, state and local governments may spend significant resources plowing roads. Who plows which roads and parking lots? Why? If state and local governments ceased offering snow plowing services, what would happen in the local economies affected by snow?

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17

EXTERNALITES

The Big Picture Where we have been: Achieving efficiency by equating marginal social benefit and marginal social cost introduced in Chapter 2 and elaborated upon in Chapter 5 is the key concept used in this chapter. Mixed goods with external costs and the problem of common resources were introduced in Chapter 16 as was the idea that public choices might improve resource allocation or might make things worse.

Where we are going: The efficiency analysis introduced in Chapter 16 is extended in this chapter to the case where private and social costs diverge and where resources are common rather than private. Public choices about how to address the resulting misallocations of resources are also analyzed.

New in the Thirteenth Edition This chapter has not had many changes from the prior edition. The introduction has been changed to reflect the new Economics in the News case at the end of the chapter, which now focuses on efforts by the state of California and other states to reduce carbon emissions. The Economics in Action case has been updated to include data through 2015.

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Lecture Notes

Externalities I.

Externalities in Our Lives •

External costs result when actions cause negative effects on bystanders. This chapter considers why private markets might not act in the social interest and whether government action can offer incentives so that pollution and overuse of common resources is less likely to occur.

An Economics in Action detail points out that many types of air pollution are less serious today in the United States than they were in the past. But rising CO2 in the atmosphere has accompanied an increase in the global temperature.

Private Costs and Social Costs of Pollution A private cost of production is a cost that is borne by the producer. Marginal private cost (MC) is the cost of producing an additional unit of a good or service that is borne by the producer of that good or service.

• An external cost is a cost of producing a good or service that is not borne by the producer but is borne by other people. A marginal external cost is the cost of producing an additional unit of a good or service that falls on people other than the producer.

• Marginal social cost (MSC) is the marginal cost incurred by the entire society—by the producer and by everyone else on whom the cost falls—and is the sum of marginal private cost and marginal external cost: MSC = MC + Marginal external cost.

Have the students consider what is included in the idea of marginal external costs. Be sure that they understand that external costs are the costs of either cleaning up the damage caused by the polluting activity or the extra costs of having to take actions to avoid the damage in the first place. Emphasize that both actions require payment by people other than the producer or consumer, which is why the costs are considered “external.”

•

The figure shows the marginal private cost curve (MC) and the marginal social cost curve (MSC) for a good with an external cost. The vertical distance between the two curves is the marginal external cost.

• Because the marginal social cost includes the marginal private cost and the marginal external cost, the marginal social cost exceeds the marginal private cost (MSC > MC) for all quantities.

• The efficient quantity of output occurs where the marginal social cost equals marginal benefit, that is, where MSC = MSB. In the figure, the efficient quantity is Q1. If the external cost reflects pollution, there is still some pollution created but it is the efficient quantity of pollution.

• An unregulated market produces where S = D. In the figure, the unregulated market is at Q0. At this level of output, MSC exceeds MSB so there is inefficient overprovision and a deadweight loss, as illustrated in the figure.

An At Issue case considers whether more should be done to eliminate carbon emissions. While most agree that incentives need to change, there is fundamental disagreement about how to change incentives. One side, represented by the Stern Review, argues for taxes on prices on carbon emissions. The other side is taken by the Copenhagen Consensus, which argues that raising the price of carbon emissions today has high present costs and low future .

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benefits.

Three Approaches to Address Negative Externalities Three approaches can be taken to address the misallocation of resources created by the negative externality • Establish property rights • Mandate clean technology • Tax or price pollution.

Establish Property Rights and the Coase Theorem •

Property rights are legally established titles to the ownership, use, and disposal of factors of production, goods, and services that are enforceable in the courts. Assigning property rights can reduce the inefficiency arising from an externality. Once property rights are given, polluters can respond by using an abatement technology or by producing less and thereby polluting less.

• The Coase theorem is the proposition that if property rights exist, if only a small number of parties are involved, and if the transactions costs are low, then private transactions are efficient. Transactions costs are the opportunity costs of conducting a transaction.

• A remarkable feature of the Coase theorem is that it does not matter if the property right is given to the creators of the externality (the polluters) or to the victims. In either case, the result will be efficient.

If the polluters value the benefits from the activity generating the pollution more highly than the victims value being free from the pollution (that is, the cost of reducing the pollution exceeds the benefit from the reduction), then the efficient outcome is for the pollution to continue. If polluters are assigned the right to pollute, the victims are not able to pay enough to convince the polluters to stop. If the victims are assigned the property right to be free from pollution, then the polluters are able to pay the victims sufficient compensation to continue polluting. Either way, the pollution continues.

If the victims value the benefits from being free from pollution more highly than the polluters value the benefits of the pollution, (that is, the benefit from reducing pollution exceeds the cost of the reduction) then the efficient outcome is for the pollution to stop. If the polluters are assigned the right to pollute, then the victims are willing to pay the polluters sufficient compensation to stop the pollution. If the victims are assigned the right to be free from pollution, then the polluters are not able to pay the victims enough to allow them to continue polluting. Either way, the pollution stops.

The role of property rights in the market. Explain that when the property rights are well defined, the owner of

that right receives the full social benefit and bears the full social cost of using that resource. Assigning property rights “internalizes” the externality. The best government policies emulate, rather than replace, the market process.

Emphasize that of all the possible government policies to increase efficiency relative to unregulated market outcomes, the ones that can potentially work the best are those that emulate the market process rather than replace it.

In the case of negative externalities like pollution, the government can choose from three policies (emissions charges, pollution taxes, or cap-and-trade), all of which require the government to assess the marginal social costs and benefits to find the initial optimal level of aggregate pollution to allow. However, the first two policies require the government to constantly monitor the market and change the taxes or emissions permits to reflect changes in: i) the benefits of the goods or services made by the polluting process, or ii) the costs of pollution abatement. The third policy forces the very firms who are doing the polluting to internalize this monitoring process by constantly comparing the cost of pollution abatement technology with the market price for tradable permits. Governments (and the taxpayers) are relieved of the monitoring and implementation cost burdens of pollution tax or emissions charge policies.

Mandate Clean Technology •

An abatement technology is a production technology that reduces or prevents pollution. Cutting production will also reduce pollution and avoid the expense of purchasing abatement technologies. Direct regulation that requires specific abatement technologies can and has reduced emissions, but economists are skeptical of this approach because it is not always the least cost alternative.

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Tax or Cap and Price Pollution •

Taxes: The government can set a tax equal to the marginal external cost, so that marginal private cost plus the tax equals marginal social cost: MSC = MC + Tax. In the figure, the appropriate tax equals the length of the double headed arrow. These sorts of taxes are called Pigovian taxes, in honor of the British economist Arthur Cecil Pigou, the British economist who first proposed this approach to externalities.

An Economics in Action case reviews the use of taxes in British Columbia, Ireland, and the United Kingdom. It concludes that whether it is overtly a carbon tax or simply a tax on gasoline, the taxes reduce carbon emissions.

•

Cap-and-trade: The government sets a limit on the total amount of pollution allowed, ideally the efficient amount. Initially the government allocates the cap across the firms by issuing marketable permits, wherein each firm is assigned permits that allow it to emit a certain amount of pollution. The firms are allowed to trade the permits. The market in permits determines the price of a permit and firms will buy or sell permits until their marginal cost of pollution reduction equals the price of a permit.

Coping with Global Externalities • •

The United States has made its own air much cleaner. But global warming and climate change cannot be solved by a single, albeit large, industrial economy.

A lower CO2 concentration is a global public good and like all public goods leads to free rider problems. No mechanisms currently compel participation in global carbon reduction programs.

An Economics in Action case reviews the global prisoners’ dilemma in reducing carbon emissions. If a nation reduces carbon emissions, its costs are higher than its trading partners, making its exports less competitive. But if all nations reduced carbon emissions, all nations would be better off.

II. The Tragedy of the Commons • •

The tragedy of the commons is the absence of incentives to prevent the overuse and depletion of a commonly owned resource. When nobody owns a resource, each individual consumer fails to consider the full opportunity cost of consuming it, so the resource is consumed at a higher than inefficient rate.

The example of the commons problem comes from medieval England. Grasslands near a town were called the commons because they were publicly accessible by all villagers to support their livestock. These grasslands were over-grazed and usually couldn’t support much livestock.

Are there examples of the “tragedy of the commons” on campus ? Have the students consider the many

problems arising from the many commons areas on campus: • Why does so much trash like candy wrappers, gum stuck to the pavement and cigarette butts litter the sidewalks and entry ways of all the buildings on campus?

• Why does the library implement such a strict rule over the level of noise that students can make (no loud conversations, laughing, etc.) in the open areas in and around the library book shelves?

Unsustainable Use of a Common Resource • • •

•

A renewable natural resource is one that replenishes itself by the birth and growth of new members of the population. For fish, the sustainable catch is the quantity of fish that can be caught year after year without depleting the stock.

A common resource is being used unsustainably of its use decreases the stock of the resource.

Sustainable use of a resource is the rate of production that can be maintained indefinitely. As more of a renewable resource is harvested, there is less left to reproduce and replace what has been harvested. If heavy harvesting depletes the resource stock to levels that are too low to replace the amount harvested, then the size of the stock available for harvest declines over time and that harvest rate is not sustainable.

If the quantity of fish harvested if less than the sustainable catch, the fish stock grows; if the quantity caught exceeds the sustainable catch, the fish stock shrinks; and if the quantity caught equals the sustainable harvest, then the fish stock remains constant and is available for future generations. .

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189

Inefficient Use of a Common Resource •

•

•

•

•

•

Marginal Private Cost: In the market for fish, the marginal private cost is the additional cost incurred by keeping a boat and crew at sea one more day. As the figure shows, marginal private costs, MC, increase as more fish are harvested due to diminishing returns. The marginal private cost curve is the same as the supply curve.

Marginal External Cost: This is the cost per additional ton that one fisher’s production imposes on all other fishers.

This cost also increases as the number of fish harvested increases.

Marginal Social Cost: The marginal private cost plus the marginal external cost, MSC. Because both of its components increase as more fish are caught, marginal social cost increases with the quantity of fish harvested.

The figure shows the MSC curve.

Marginal Social Benefit and Demand: The marginal private benefit, MB, is the price consumers are willing to pay for an additional quantity of fish. If there is no external benefit, the marginal private benefit equals the marginal social benefit. As shown in the figure, the marginal private benefit (and hence the marginal social benefit) decreases as more fish are harvested and consumed. This curve is the same as the demand curve.

Overfishing equilibrium: The market demand curve is the marginal social benefit curve because there are no external benefits. The market supply curve is the marginal private cost curve. In the figure the market equilibrium is 30 tons of fish. The efficient quantity sets the MSC equal to the MSB and is 20 tons of fish in the figure. The equilibrium quantity exceeds the efficient quantity. A deadweight loss occurs and the fish stock is depleted.

Deadweight Loss from Overfishing: Every fish harvested for which the marginal social cost exceeds the marginal social benefit increases the size of the deadweight loss.

Achieving an Efficient Outcome Society can use three different methods to achieve the efficient outcome for common resources: • Property rights: Property rights can be assigned to the common resource. The owner then will receive the marginal benefit of using the resource. The resource will be used efficiently and not overused. However, assigning property rights to some resources, such as the fish in the ocean, is not always feasible.

• Production quotas: Quotas can be set for the efficient total catch, with the total divided among all users.

However, it is in every user’s self-interest to cheat on the quota, so the quota might be ineffective. In addition, the marginal cost of using the resource varies across users, so an equal allocation of quotas generates an inefficient outcome.

• Individual transferable quotas: An individual transferable quota scheme might be used. An individual transferable quota (ITQ) is a production limit that is assigned to an individual who is free to transfer the quota to someone else.

• Less efficient users with higher marginal costs are willing to sell their quotas to more efficient harvesters who are willing to buy them.

• The price of the quota will equal the difference between the marginal social benefit of the quota minus the marginal private cost of using the quota. In the figure, at the efficient quantity the price of an ITQ is $3 per pound. Note that marginal private cost + price of a quota = marginal social cost.

• Users with the quotas will use the resource until the marginal social benefit equals the marginal private cost plus the price of the quota (the marginal private cost plus the price of the quota equals the marginal social cost). If the quota was set at the efficient quantity, the equilibrium is efficient.

An Economics in Action application considers ITQs. Evidence from Iceland, New Zealand, and Australia suggests they work well to sustain fish stocks. But they also reduce the size of the fishing industry, making the industry .

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oppose ITQs in every country in which they are proposed. The opposition was not large enough to block them in New Zealand and Australia but it did in the United States for a time. Since 2004 they have been used in 28 U.S. fisheries. Economists have found them to be an effective tool.

III. Positive Externality: Knowledge Private Benefits and Social Benefits • • •

A private benefit is a benefit that the consumer of a good or service receives. Marginal private benefit (MB) is the benefit from an additional unit of a good or service that the consumer of that good or service receives.

An external benefit from a good or service is a benefit that someone other than the consumer receives. A marginal external benefit is the benefit from an additional unit of a good or service that people other than the consumer enjoy.

Marginal social benefit (MSB) is the marginal benefit enjoyed by the entire society—by the consumer and by everyone else who enjoys a benefit—and is the sum of marginal private benefit and marginal external benefit: MSB = MB + Marginal external benefit.

•

The figure shows the marginal private benefit curve (MB) and the marginal social benefit curve (MSB) for a good with an external benefit. The vertical distance between the two curves is the marginal external benefit.

• Because marginal social benefit includes marginal external benefit, the marginal social benefit exceeds the marginal private benefit (MSB > MB) for all quantities.

• The efficient quantity of output occurs where the marginal social benefit equals marginal cost, that is, where MSB = MSC. In the figure, the efficient quantity is Q1.

• An unregulated market, however, produces where S = D. In the figure, the unregulated market equilibrium is Q0. At this level of output, MSB exceeds MSC so there is a deadweight loss, as illustrated in the figure.

Government Actions in the Market for with External Benefits The efficient outcome is production of the quantity at which MSB = MSC. There are three main methods that the government can use to cope with external benefits: • Public production: One possibility is public production, when a public authority that receives its revenue from the government produces the good or service. (Public colleges are an example.) In this case, the government can fund the authority to produce the efficient quantity.

• Private subsidies: A subsidy, a payment that the government makes to private producers, can be used. If the government pays the producer a subsidy equal to the marginal external benefit, then the quantity produced by the private firm increases to that at which the marginal cost equals the marginal social benefit and an efficient allocation of resources occurs. In the figure, the correct subsidy is equal to the length of the double headed arrow.

• Vouchers: A voucher, a token that the government provides to households to buy specified goods or services, can be used. Households receiving a voucher pay a lower price to acquire the specific good or service, which increases their demand and increases the quantity consumed.

.

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Bureaucratic Inefficiency and Government Failure •

• •

Government intervention might not make the marginal social benefit equal the marginal social cost. This situation is government failure.

• Overproduction can result if bureaucrats seek to maximize their budgets and programs.

• Underproduction can result if bureaucrats pad their budgets and have wasteful spending. In this case, the costs of enterprises run by bureaucracies often exceed the minimum efficient cost.

Private subsidies might overcome some of the problems associated with bureaucracies, but the subsidy budget ultimately depends on bureaucracies. It is also in the best interests of those receiving the subsidies to try to maximize it, leading to rent seeking activities and lost resources.

Vouchers have four advantages when it comes to insuring the efficient quantity of the good or service is produced: • They can be used for public or private provision, which creates competition.

• Governments set the value and total size of voucher programs which can avoid bureaucratic padding and overprovision.

• The public contribution is spread thinly across many participants, leaving little incentive for individual recipients to engage in rent seeking.

• The final consumer has the buying power, forcing firms to compete by offering more and better services.

An Economics in Action case considers charter schools’ role in improving educational quality and controlling costs.

Public provision, private subsidies and vouchers can all increase the quantity of education, but not necessarily the quality while controlling costs. Charter schools are funded as public schools, but set their own educational policies.

When spaces for students in charter schools are allocated by lottery (thereby eliminating self-selection bias), charter school performance can be more easily tested. So far, charter schools are doing well both in terms of achieving educational standards and controlling costs.

The final Economics in the News case considers the efforts of particularly the state of California, but also other states, to aggressively work to reduce carbon emissions even in light of the Trump administration abandoning the Paris Accord.

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Additional Problems 1.

Fast-Food Trash Be Gone!

To help clean up the city, the Oakland City Council is considering a tax on fast-food restaurants, gas station markets, liquor stores and convenience stores that serve take-out food or beverages. The revenue from the tax will be used to help pay the costs of clean-up crews picking up burger wrappers and soda cans.

CNN, February 6, 2006 a. What is the external cost associated with takeout food and beverages? b. Draw a graph to illustrate and explain why the market for take-out food and beverages creates a deadweight loss. c. Use your graph to illustrate and explain how Oakland’s policy might improve efficiency.

2.

The table shows the marginal benefit and marginal cost Marginal Marginal of driving a private car into central London. How many benefit cost cars a day enter London? In 2004, the city introduced a Number (pounds (pounds per congestion charge of £5 per car per day. How many cars of cars per car) car) a day entered London after the congestion charge was 10,000 17 2 levied? What was the reduction in congestion and how 30,000 14 4 much revenue did the congestion charge raise for the 60,000 11 6 city?

90,000 8 8 120,000 5 10

Solutions to Additional Problems 1.

a. b.

c.

The external cost is the pollution from discarding the wrappers and beverage containers after use.

Figure 17.1 shows the market for take-out food and beverages. The marginal social cost, MSC, exceeds the marginal private cost, MC, because of the marginal external cost of pollution. The MC curve, which is also the supply curve, lies below the MSC curve. The equilibrium quantity of take-out meals, which is determined at the intersection of the supply curve and the demand curve, is 50 million per month. The efficient quantity of take-out meals, which is determined at the intersection of the marginal social cost curve and the marginal social benefit curve, is 30 million meals per month. The resulting deadweight loss from the overproduction is equal to the area of the grey triangle illustrated in the figure. This deadweight loss occurs because the consumers of take-out meals do not pay the full marginal social cost of their take-out meals. As a result the quantity of take-out meals consumed exceeds the efficient quantity.

Presuming the tax equals the marginal external cost, which in Figure 17.1 is $3 per meal, then in Figure 17.1 the tax shifts the S = MC curve so that it is the same as the MSC curve. In this (optimal) case, the equilibrium quantity becomes the same as the efficient quantity and there is no deadweight loss. .

EXTERNALITIES

2.

193

Before the congestion charge, 90,000 cars per day entered central London because that is the quantity at which the marginal benefit to the driver equals the marginal cost to the driver. (Both equal £8.) After the congestion charge, the marginal cost to the driver increased by £5, the amount of the charge. So after the congestion charge, 60,000 cars per day entered central London because that is the quantity at which the marginal benefit to the driver equals the marginal cost to the driver. (Both now equal £11.) The congestion was reduced by 30,000 cars per day. The city gains £5 per car entering central London. 60,000 cars now enter central London, so the city gains revenue of £5 per car  60,000 cars, which is £300,000 per day.

Additional Discussion Questions 1.

Do good fences make good neighbors? To illustrate the role of property rights and prices in promoting efficient resource allocation within a market, tell this story of a hearty apple tree that adorned the central square on the campus of a local university. Each spring, an economics student watched as the beautiful white apple blossoms transformed into little green spheres that could eventually become juicy red delicious apples—if they were allowed to mature. But he never once in his four years at school saw a single mature apple hanging from that tree. Ask students why they think that was the case. A few students will recognize that apples were often picked before they were fully ripe. Every student wanting an apple assumed that waiting to pick one when it was truly ripe would be futile, because someone else would surely pick it one or two days earlier when it was almost as ripe and still somewhat delicious. However, those people would think picking it only two days earlier would also be futile, because someone else might pick it a day or two days earlier than that when the apples were still somewhat good for eating if they were allowed to ripen on the shelf. In this way the “best” harvest day for the apples regressed until the very first day that any one apple would even be worth trying to eat if it were left on the shelf to ripen. Every apple on the tree was harvested before it was allowed to ripen sufficiently to create the highest possible quality.

How else could the apples have been brought to their highest valued use to society? The problem was that no individual had an ownership claim, or property right, to the tree and the apples upon it. Perhaps, because it was a state university, all the state taxpayers could lay claim to the tree.

Either way, no one could realistically expect to receive the full benefits that fully mature apples could bring by protecting and maintaining the tree. This reality is at the heart of the phrase, “What everybody owns, nobody takes care of.” A lack of property rights meant that nobody would be held responsible for the full opportunity cost of failing to wait until the apples were mature. Many different individuals acted in a way that destroyed all the potential value of those apples to society, and none were held accountable for their actions.

Do property rights motivate socially beneficial behavior using a “carrot” or a “stick”? The answer is both. If someone were granted the property rights to the apple tree and its fruit, pilfering would be an illegal and punishable offence. The owner would receive the full benefits from maintaining the tree and waiting to harvest the apples until they were mature and would maximize profit by picking the apples when their marginal cost equals their marginal benefit.

2.

What is the optimal penalty for skipping class? Some professors penalize students with excessive, unexcused absences by making a portion of a student’s course grade depend on his or her attendance record. One reason behind such a policy is that students interact in class and benefit each other with their insightful remarks and questions, creating a positive externality. So a student missing classes deprives other students of these external benefits. To draw a similar perspective on the issues of recycling and pollution abatement, ask if a zero-tolerance policy giving an F to any student with even one unexcused absence is optimal for the class. Just as a rule requiring zero absences seems overly harsh, so would a rule requiring zero pollution. Zero pollution can be achieved only by stopping all

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production, all transportation, and, literally, all human activity. Clearly a balance between the marginal social costs and marginal social benefits is required.

3.

Evaluate the statement: “If this program saves even one life, it will have been worth the money.” Ask the following questions: Is the value of one life saved truly immeasurable? What is the opportunity cost of expending resources to save one life? Could more than one life have been saved if the same resources were used for a different policy? Should we try to fund all policies that could potentially save one life? Students should see the problem with this idea. Just because something has value doesn’t mean we should use resources to produce it. We must compare the value with its cost.

4.

Can you apply the Coase theorem in your own life? Ask your students if they’ve ever had the experience of studying for an important exam when a neighbor decides to throw a party or play music loudly. At the very least, students should understand that a party could interfere with their ability to study effectively, generating an external cost. According to the Coase theorem, this externality can be effectively dealt with by private transactions. The student studying can offer the partying student money to stop the party (or at least move the party elsewhere). The partying student will accept the money if the value of that money is at least as great as the cost of moving or stopping the party. Whether the transaction takes place will depend on how much the quiet time is worth to the studying student and how much the party is worth to the partying student. If efficiency would result in more quiet time and less partying, then this private transaction will result in the efficient outcome.

5.

Are laws that ban smoking economically efficient? Many cities are banning smoking in all public places including bars and restaurants. Consider alternate solutions to a complete ban, especially given an application of Coase’s theorem to smoking in shared offices. If smokers owned the air, would smoking necessarily occur? What if nonsmokers owned the air?

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MARKETS FOR FACTORS OF PRODUCTION

The Big Picture Where we have been: Chapter 18 uses the productivity and cost definitions and concepts introduced in Chapter 10 and the conditions for maximum profit introduced in Chapter 11. It builds on these concepts to explain value of marginal product and to show how factor markets work.

Where we are going: Chapter 18 explores the workings of factor markets and the resulting distribution of income. The labor, capital, and natural resource markets are introduced here and Chapter 19 studies the implications of factor market equilibrium for the distribution of income and trends in the distribution.

New in the Thirteenth Edition The introduction to the chapter has been updated to focus on Uber and Airbnb and how they are transforming how people get rides and hotel rooms in the “sharing economy.” It included the idea that new technologies change the jobs people do, the wages they earn, and how they use capital. This theme is continued with two new applications, one Economics in the News about how the expansion of Airbnb has impacted the hotel market in Boston and one at the end of the chapter on the impact of Uber on the taxi market. Data have been updated in other applications.

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Lecture Notes

Markets for Factors of Production • • •

I.

Firms choose the quantities of factors they demand in order to maximize their profit.

Households choose the quantities of factors they supply.

The interaction of demand and supply determines factor prices.

The Anatomy of Factor Markets

The four factors of production are labor, capital, land (natural resources), and entrepreneurship.

Labor services are traded in the labor market. The price of labor is the wage rate. Most labor services are traded on a job contract.

• Capital goods are traded in goods markets. Capital services are traded in rental markets. The services of capital that a firm owns have an implicit price that arises from depreciation and interest costs. Firms that buy capital and use it themselves are implicitly renting the capital to themselves.

• The price of the services of land is a rental rate. Nonrenewable natural resources are resources that can be used only once.

• Entrepreneurs receive the profit (or loss) that results from their business decisions and their services are not traded in markets.

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Looking back Before you jump into the content of this chapter, provide your students with some context and perspective.

1. Recall the big issues of microeconomics discussed in Chapter 1. Point out that the course so far has addressed the first two questions: “What?” and “How?” and that you’re now going to address how markets determine the answer to the third question: “For whom?”

2. Spend a minute or two reviewing the course so far. Point out that Chapters 3–7, demand and supply and its extensions and applications studied the flows of goods and services from firms to households.

Chapters 8 and 9 studied the choices of households. Chapters 10–15 studied the choices of firms. Now, we’re going to study the flow of goods and services from firms to consumer households in the product market and the flow of factors of production from households to firms in the factor markets.

3. Understanding choices at the margin, demand and supply, and market forces that bring equilibrium and coordinate activity to produce efficiency are all used in this chapter. Emphasize the power of the economic tools that the students already know and the payoff from keeping on top of the entire course.

II. The Demand for a Factor of Production The Value of Marginal Product •

•

The demand for a factor of production is called a derived demand because it is derived from the demand for the goods and services produced by the factor.

The value to the firm of hiring one more unit of a factor of production is called the factor’s value of marginal product. It is equal to the price of a unit of output multiplied by the marginal product of the factor of production: VMP = P  MP

Labor (hours per day)

Output (units per day)

200

1,000

300

3,000

400

4,000

500 .

4,500

Marginal product of labor (units per day)

Value of marginal product (dollars)

20

140

10

70

5

35

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The table shows the calculation of the VMP for a firm whose output has a price of $7 per unit.

A Firm’s Demand for Labor • • •

The firm hires the quantity of labor that maximizes its profit by comparing the value of one more worker (the VMP) to the cost of employing one more worker, the wage rate.

As more labor is employed, the MP diminishes (as shown in the table above). So as more labor is employed, the VMP diminishes.

If VMP of labor exceeds the wage rate, the firm increases its profit by employing one more worker; if VMP is less than the wage rate, the firm increases its profit by employing one less worker; and, if VMP equals the wage rate, the firm is employing the profit-maximizing quantity of labor.

A Firm’s Demand for Labor Curve

The value of marginal product curve is the firm’s labor demand curve.

• Because the VMP of labor diminishes as the quantity of labor employed increases, the demand curve for labor is downward sloping.

The profit-maximizing level of inputs implies the profit-maximizing level of output. If you wish to go beyond the analysis in the book, you can take a bit of time to show your students the basic math of the equivalence of the two conditions for maximum profit—MR = MC and W = VMP—and give them a good intuitive grasp of what is going on. There are six steps: 1. The cost of producing one more unit, MC, equals the cost of one more worker, W, divided by that worker’s marginal product, MP. That is: MC = W/MP. 2. The revenue from selling one more unit, MR, equals the revenue from hiring one more worker, VMP, divided by that worker’s marginal product, MP. That is: MR = VMP/MP. 3. Setting these two equations side by side: MC = W/MP and MR = VMP/MP is a tiny step to see that MC = MR implies W = VMP. 4. Just write MC = MR implies W/MP = VMP/MP; multiply by MP and W = VMP. 5. Now put in some numbers to make the student who freezes on symbols more comfortable.

6. Finally, just talk about what the equations mean. Explain that the marginal worker costs $x and generates a revenue of $x, so that worker is just worth hiring. Hiring one more worker costs $x but generates less than $x in revenue, so is not worth hiring. Hiring one fewer worker saves $x but forgoes more than $x in revenue, so profit falls. Go on to point out that one unit of output produced by the marginal worker sells for $p and it costs $x/MP, which equals marginal cost.

Changes in a Firm’s Demand for Labor

Three factors can change the demand for labor and shift the labor demand curve: • If the price of the firm’s output changes, the VMP changes, which changes the demand for labor. An increase in the price of the output increases the demand for labor and shifts the demand curve rightward.

• If the prices of other factors of production change, in the long run the demand for labor changes.

An increase in the price of a substitute factor leads the firm to increase the demand for labor.

• If a change in technology increases the productivity of one type of labor, the demand for this labor increases and the demand curve shifts rightward.

III. Labor Markets A Competitive Labor Market • •

The market demand for labor is determined by adding together the quantities of labor demanded by all the firms in the market at each wage.

The market supply of labor is derived from the supply of labor decisions made by individual households. .

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Aren’t households demanders? Point out that in the labor market, the tables have been turned compared to the goods and services market. The household that is on the demand side of the markets for consumer of goods and services is now on the supply side of the market.

•

•

A person’s reservation wage is the lowest wage rate for which the person is willing to supply labor.

As the wage rate rises above the reservation wage, there is a substitution effect and an income effect. The substitution effect occurs because a higher wage rate increases the opportunity cost of leisure, which increases the quantity of labor supplied. The income effect occurs because an increase in the wage rate increases the person’s income and so increases the demand for leisure, which decreases the quantity of labor supplied.

At lower wage rates, the substitution effect dominates the income effect, so a rise in the wage rate increases the quantity of labor supplied. At higher wage rates, the income effect dominates the substitution effect, so a rise in the wage rate decreases the quantity of labor supplied and the supply of labor curve bends backward.

What’s your reservation wage? Ask the students if they would be willing to work 40 hours each week at a wage rate of $20 per hour (which is about $40,000 per year). Next, ask them whether they would increase their labor supplied to 48 hours per week if they could earn $40 per hour (about $80,000 per year, if working 40 hours per week). Most students would be willing to work more hours per week at this wage rate. Then ask them how many hours per week they would work if they were paid $10,000 per hour.

In this case, working only one day per week would garner them about $8 million per year, leaving the remaining six days of each week to enjoy their high income. Many would not be willing to continue working 48 hours a week, thereby creating a backward-bending supply of labor curve.

• •

The supply of labor increases (shifts rightward) when the adult population increases and when capital and technology used in the home increase.

Labor market equilibrium determines the wage rate and employment.

Comparing competitive output markets with competitive input markets. Just as the perfectly competitive firm in the market for a good or service is a price taker in that market, so the individual household in a perfectly competitive factor market is a price taker. Also, the firm that buys the services of the factor of production is a price taker in a perfectly competitive factor market. Even in the market for land, which is in perfectly inelastic supply, the individual landowner faces a perfectly elastic demand for his or her land.

Differences and Trends in Wage Rates • • •

Differences in demand and supply across labor markets make wage rates unequal. The highest wage rates are earned in markets where the value of marginal product is high and where few people have the ability and training for the job.

Because the value of marginal product increases over time as new capital and new technologies increase labor productivity, wage rates also increase over time.

Wage inequality has increased recently with high wage rates increasing more rapidly than low wage rates. Some low wage rates have stagnated or fallen. The new information technologies increased the productivity and wage rates of already high-paid workers. Globalization has brought increased competition for low-skilled workers and lowered the wages of already low-paid workers.

An Economics in Action case has been updated with current Bureau of Labor Statistics data on U.S. wages.

The difference between median and mean income is highlighted as more Americans earn less than the .

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average income. The application also notes that higher than average wage jobs typically require college and post graduate degrees.

A Labor Market with a Union

A labor union is an organized group of workers that aims to increase the wage rate and influence other job conditions. The text analyzes how unions impact the labor market equilibrium for union workers and how this impacts nonunion workers.

• To reach their goals, unions attempt to restrict the quantity of labor available for the firm to employ (shifting the labor supply curve leftward).

• Unions also attempt to influence the demand for labor and to increase the demand for labor (shifting the labor demand curve rightward) with the following strategies: • Increase the marginal product of union members to increase the demand for their labor.

• Encourage import restrictions to increase the demand for union-made U.S. products.

• Support minimum wage laws to raise the cost of non-union low-skilled labor.

• Support immigration restrictions to decrease the supply of competitive labor.

• In equilibrium, if a union decreases the supply of labor, there will be fewer jobs at higher wages. If it is able to also increase the demand for union labor, this will further increase wages and offset some of the decrease in employment. The market for nonunion labor will also be effected workers unable to get union jobs increase the supply.

Monopsony in the Labor Market • •

A monopsony is a market in which there is a single buyer.

For a monopsony, the marginal cost of labor exceeds the wage rate because the monopsony faces an upward-sloping labor supply curve. To attract one more worker, the monopsony must offer a higher wage rate, and it must pay this higher wage rate to all its workers.

Example: The idea that the marginal cost of labor is somehow different from the wage rate is often confusing for students. Be sure to go through the intuition and the math calculations for the marginal cost of labor several times. As in the table below, if employment rises from 200 to 300 hours per day, the wage rate will rise from $3 to $6. The total cost of labor rises from $600 to $1,800, a difference of $1,200. The change in total cost divided by the change in employment will be $1,200/100 = $12. Intuitively, all 200 hours of labor were earning a wage of $3 per hour until the next 100 hours of labor were employed. To entice those units of labor to supply their services, the wage rate rose to $6 for all 300 units of labor. As a result, the firm pays $6 for the new 100 hours of labor, and pays an additional $3 for the 200 hours of labor it was previously employing. That’s $600 for the new 100 units of labor and an additional $600 for the wage increase paid to the original 200 units of labor, for a marginal cost of labor equal to $1,200/100 = $12 again.

What about “wage discrimination”? Monopolies faced a downward-sloping demand curve for their output, resulting in a marginal revenue curve that was below the demand curve. To sell more output, monopolies had to lower the price. The story for monopsony is similar. Because a monopsony faces an upward-sloping supply curve for labor, to hire more labor, monopsonies have to raise the wage, resulting in a marginal cost of labor curve that is above the labor supply curve. Some of your especially attentive students will remember that marginal revenue and demand were the same when the firm could practice perfect price discrimination. In the basic model of monopsony, we’re assuming there’s no “wage discrimination.” Every worker is paid the same wage, just as every customer in a single-price monopoly is charged the same price.

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•

•

•

The first two columns of the table show the labor supply schedule and the last column Labor has the marginal cost of labor, MCL, schedule. (hours per The MCL curve is upward sloping and lies day) above the labor supply curve.

200 To maximize its profit, a monopsony hires the quantity of labor where its MCL is equal to VMP and then pays the wage rate 300 necessary to attract that quantity of labor. In the figure, the monopsony employs 300 400 hours of labor per day and pays a wage rate of $6 per hour.

A monopsony hires less labor and pays a 500 lower wage rate than it would if it were operating in a competitive labor market. In the figure, in a competitive labor market 400 hours of labor would be employed and the wage rate would be $9 per hour.

Wage rate (dollars per hour)

Marginal cost of labor (dollars per hour)

3 12 6 18 9 24 12

A Union and a Monopsony •

If a union, a monopoly seller of labor services, faces a monopsony buyer of labor services, the situation is called bilateral monopoly. In a bilateral monopoly, the wage rate is determined by bargaining and depends on the costs that each party can inflict on the other if they fail to agree upon a wage rate.

Examples of bilateral monopoly: Have the students consider the relationship between professional team owners (NBA, NFL, etc.) and the players who work for these owners. Such markets are classic examples of bilateral monopoly. Team owners operate a legal cartel and maintain strict rules for hiring labor (drafting and trading players) that prevent most of the competition among team owners who might want to sign the same player. So the owners are close to a monopsony. The best players with uniquely talented skills cannot be duplicated in the short run, so these players have a monopoly on their skills. The resulting bilateral monopoly equilibrium is such that player’s wages in general are high compared to most all other professions. This observation might surprise the students because it suggests that bargaining position of the players is greater than that of the owners.

Monopsony and Minimum Wages •

The imposition of a minimum wage in a monopsony labor market might increase both the wage rate and employment. The minimum wage makes the supply of labor perfectly elastic over some range of employment. Over this range the supply curve is horizontal and the MCL of an additional employee equals the minimum wage rate. If this part of the supply curve of labor intersects the monopsony’s VMP curve, the minimum wage increases both the quantity of labor employed by the monopsony and the wage rate paid by the monopsony. The wage rate equals the minimum wage rate.

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The At Issue case presents the argument over whether monopolies are always bad, focusing on the NCAA. Robert Barro argues that the NCAA monopoly hurts the market for college athletics. Richard McKenzie and Dwight Lee argue that the NCAA monopoly has helped college athletics.

IV. Capital and Natural Resource Markets • •

Capital rental markets and land rental markets can be understood using the same basic ideas from the competitive labor market.

Markets for nonrenewable natural resources are different.

Capital Rental Markets • •

The demand for capital is equal to the value of the marginal product of capital, and equilibrium in the market for capital occurs where the value of the marginal product of capital is equal to the rental rate of capital.

Whether a firm rents or buys capital depends on a comparison of the cost of a purchase relative to the stream of rental costs incurred over some future period. The Mathematical Note develops this result and the concept of present value.

An Economics in the News case considers the impact of Airbnb on the Boston Hotel market. It concludes that the Boston hotel market has still grown even while Airbnb has expanded its service in the area and uses demand and supply curves to complete the analysis.

Land Rental Markets • •

The demand for land is based on the value of marginal product of land, and equilibrium in the market for land occurs where the value of the marginal product is equal to the rental rate of land.

The supply of land is fixed, so the supply curve is vertical.

Nonrenewable Natural Resource Markets •

• •

•

Oil, gas, and coal are examples of nonrenewable natural resources that are used to produce energy.

• The demand for oil is determined by the value of the marginal product of oil—the fundamental influence on demand—and the expected future price of oil—the speculative influence on demand. The opportunity cost for a trader of buying and holding oil is the interest rate that could be earned as an alternative.

• The supply of oil is determined by known oil reserves, the scale of current oil production facilities, and the expected future price of oil. The marginal cost of extracting oil increases, which results in an upward-sloping supply curve for oil.

The market fundamentals price of oil is determined by the value of marginal product of oil and the marginal cost of extraction.

Speculative forces based on expectations of the future price also can affect the current price. When expectations are revised so that the price is expected to be higher in the future, the current demand increases and the current supply decreases. Speculation can drive a wedge between the equilibrium price and the market fundamentals price.

The Hotelling Principle states that traders expect the price of a nonrenewable natural resource to rise at a rate equal to the interest rate. The actual path of a nonrenewable natural resource will not necessarily rise at this rate because the actual path depends on exploration and technological changes.

An Economics in Action case considers the U.S. and world market for oil. It analyzes why energy independence for U.S. oil production won’t mean the U.S. is not affected by changes in the global price of oil.

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When will we run out of oil? Students are very interested in the doomsday issue. When will we run out of nonrenewable resources such as the hydrocarbon fuels? (Minerals are different because they can be recycled. They are nonrenewable, but somewhat durable.) Some numbers for your class: At the current usage rate and the current growth rate of usage and assuming that we will discover no new reserves, the world runs out of coal in 2082, natural gas in 2043, and oil in 2030. But, assure them this will never happen and explain the reasons: As the resource becomes more scarce, the price increases, causing a number of actions: 1) society is more willing to explore previously unexplored areas which were “too expensive” to explore before the price increase, and new deposits will be discovered, 2) the remaining level of resources in existing deposits that were “too expensive” to extract are now more affordable to extract and will be made available, 3) Alternate resources that were “too expensive” to use as a substitute resource before the price change to be efficient are now efficient to use, decreasing the rate of use of the initial resource. With an increase in resource prices, the “empty tank” keeps on extending.

Doomsday and the Hotelling Principle: Another really neat bit of analysis that addresses the doomsday scenario head-on is the Hotelling Principle. The textbook keeps this material as simple as possible without losing the point. You can elaborate a bit and explain the end-game a bit more fully if you wish. To do so, you draw a demand curve for coal that hits the y-axis at the so-called “choke price.” Explain that today’s expectation of the choke price and today’s expectation of the year that the resource runs out determines today’s price. That price, P, is the expected choke price, PCHOKE, discounted by the expected number of years T to running out, T. So P = PCHOKE/(1 + r) . (Your students will likely have to have had some exposure to the concept of present value to understand this.) No one actually performs the calculation of this equilibrium price, but rational owners of reserves of the natural resource behave as if they performed the calculation.

At each point in time, the future price is expected to rise at a rate equal to the interest rate. But the actual price fluctuates because expectations about the choke price and the number of years left fluctuate. And historically, the prices of many resources have fallen because the T has continually become unexpectedly longer.

Economics in the News at the end of the chapter describes the impact of Uber on the taxi industry. It concludes that it has had a relatively small negative impact on t the has had a relatively small negative impact on the wages of traditional salaried taxi drivers, a large impact on the number of self-employed taxi drivers, and that self-employed taxi drivers have higher hourly earnings which is credited to a more efficient use of their time given the sharing technology.

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Mathematical Note Present Value and Discounting Rent-versus-Buy Decision

Firms must compare the current cost of buying capital with the future cost of renting the capital

Comparing Current and Future Dollars •

The returns to capital come in the future, so the firm must convert the future marginal revenue product of capital to a present value. The present value of a future amount of money is the amount that, if invested today, will grow to be as large as that future amount when the interest that it will earn is taken into account. Discounting is converting a future amount of money into a present value.

Compound Interest

Compound interest is the interest on an initial investment plus the interest on the interest that the investment has already earned.

• To illustrate present value, begin with the relationship between an amount invested today (Present value), the interest income that it earns (Interest income), and the amount it grows to in the future (Future amount): Future amount = Present value + Interest income • The interest in the first year is equal to the present value multiplied by the interest rate, r, so Amount after 1 year = Present value + (Present value  r) = Amount after 1 year = Present value  (1 + r).

• The amount after 2 years is equal to the amount after 1 year multiplied (1 + r), so Amount after 2 years = Present value  (1 + r)2 • Similarly, the amount of money that a person has n years in the future equals: Amount after n years = Present value  (1 + r)n.

• Example: $100 saved for 5 years at 6 percent interest equals $100  (1 + 0.06)5 = $133.82.

Discounting a Future Amount

To discount a future amount into its present value, the formulas above need to be rearranged.

• Rearranging the formula for the amount of money after 1 year shows that: Amount of money1 year in the future Present value = .

1+ r • In turn, rearranging the formula for the amount of money after 2 years shows that: Amount of money 2 yearsin the future Present value = .

(1 + r )2 • Similarly, the present value of an amount of money n years in the future is: Amount of moneyn yearsin the future Present value = .

(1 + r )n • Example: $300 to be paid in 4 years when the interest rate is 5 percent per year for each year has a present value of $300/(1 + 0.05)4 = $246.81. As a check, $246.81  (1 + 0.05)4 = $300.

Present Value of a Sequence of Future Amounts • •

If money payments are to be paid at several times in the future, the present value of this stream of payments is equal to the sum of the present value of each money payment.

Example: $100 is paid for the next three years at the end of each year. The interest rate is 6 percent.

The present value equals $100/(1 + 0.06) + $100/(1 + 0.06)2 + $100/(1 + 0.06)3 = $267.30.

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The Decision •

Renting a unit of capital will require payments to be made in the future. The present value of this stream of payments is compared to the price of buying the unit of capital. If the price is greater than the present value of rental payments, the capital is rented while if the price is less than the present value of the rental payments, the capital is purchased.

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Additional Problems 1.

Barry makes party ice. He employs workers to bag the ice who can produce the quantities of ice in an hour that are listed in the table. The market for ice is competitive and Barry can sell ice for 50¢ a bag. The labor market is competitive and the equilibrium wage rate of baggers is $10.00 an hour. a. Calculate the marginal product of the workers. b. Calculate the value of marginal product of the workers. c. Find Barry’s demand for labor curve. d. How much ice does Barry sell?

Number of workers 1 2 3 4 5 6 7 8

Quantity of ice (bags) 40 100 180 240 290 330 360 380

2.

Back at Barry’s ice making plant described in problem 1, the price of party ice falls to 25¢ a bag but baggers’ wages remain at $10.00 an hour. a. What happens to Barry’s marginal product? b. What happens to his value of marginal product? c. What happens to his demand for labor curve? d. What happens to the number of baggers that he employs?

3.

Back at Barry’s party ice shop described in problem 1, baggers’ wages increase to $20 an hour, but the price of ice remains at 50¢ a bag. a. What happens to his value of marginal product? b. What happens to Barry’s demand for labor curve? c. How many baggers does Barry employ?

4.

What is discounting? What is present value? How do the two relate?

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Solutions to Additional Problems 1.

a.

b.

c. d.

2.

a. b.

c.

Marginal product of labor is the increase in total product that results from hiring one additional bagger. For example, if Barry increases the number of baggers hired from 2 to 3, total product (the quantity of ice) increases from 100 to 180 bags.

The marginal product of 2.5 baggers is 80 bags of ice. The table shows the remainder of these marginal products.

Number of workers 1

Quantity of ice (bags)

Marginal product (bags)

40

2

100

3

180

4

240

5

290

6

330

7

360

8

380

60 80 60 50 40 30 20

The value of marginal product of labor is the Value of increase in total revenue that results from hiring Marginal marginal one additional bagger, which equals the marginal Number product product product multiplied by the price. The second table of (bags) (dollars) shows that the marginal product of 2.5 workers is 80 bags of ice. Barry sells the ice for 50¢ a bag, so workers this worker’s value of marginal product is 80 bags 1.5 60 30  50¢ a bag = $40. The schedule showing the value 2.5 80 40 of marginal products in the table are calculated 3.5 60 30 similarly.

4.5 50 25 Barry’s demand for labor curve is the same as his 5.5 40 20 value of marginal product curve.

6.5 30 15 Barry sells 370 bags. Barry hires the number of 7.5 20 10 baggers that makes the value of marginal product equal to the wage rate of $10 an hour. When Barry hires 7.5 baggers, marginal product is 20 bags of ice in an hour, which Barry sells for 50 cents a bag. The value of marginal product is $10—the same as the wage rate. Barry hires 7.5 baggers and produces 370 bags of ice an hour.

The marginal product does not change. The marginal product that results from hiring 2.5 baggers an hour is still 80 bags of ice.

The value of marginal product decreases. If Barry hires 2.5 baggers an hour, the marginal product is (still) 80 bags of ice. Now Barry sells the ice for 25 cents, so the value of marginal product is 80 bags  25¢ a bag = $20, down from $40.

Barry’s demand for labor decreases, and his demand for labor curve shifts leftward. Barry is willing to pay the baggers their value of marginal product, and the fall in the price of ice has lowered their value of marginal product. .

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3.

d.

Barry will hire fewer baggers. At the wage rate of $10.00, the number of baggers Barry hires decreases to 5.5 as the demand for labor curve shifts leftward.

a.

The value of marginal product does not change. If Barry hires 2.5 baggers an hour, the marginal product is (still) 80 bags of ice and Barry sells the ice for 50 cents a bag, so the value of marginal product remains at $40.

Barry’s demand for labor remains the same because the value of marginal product of labor has not changed.

Barry will hire fewer baggers. At the wage rate of $20 an hour, Barry hires the number of baggers that makes the value of marginal product equal to $20 an hour. Barry now hires 5.5 baggers an hour—down from 7.5 an hour. The marginal product that results when Barry hires 5.5 baggers is 40 bags of ice an hour, and Barry sells this ice for 50 cents a bag. The value of marginal product is $20 an hour, which is equal to the wage that Barry must now pay.

b. c.

4.

207

Discounting is converting a future amount of money into a present value. If a firm did not receive money today but instead received that money in the future, the firm would forgo the interest that this sum of money would have earned over that period. The present value of a future amount of money is the amount that, if invested today, grows to be as large as that future amount when the interest that it earns is taken into account. If a person is to receive a number of periodic payments in the future, then that person can use discounting to establish the present value of that future income stream.

Additional Discussion Questions 1.

Do advances in technology replace jobs with capital and increase unemployment?

Emphasize that the firm’s demand curve for labor depends on the value of marginal product (VMP) of labor, which is comprised of both the marginal product (MP) of labor and the value to the firm of the goods or services labor helps produce, which is price (P). Have the students mentally work through the following series of impacts that an increase in the MP of capital has on the labor market in the long run: What happens to the demand for labor when capital becomes more productive? Point out that if the firm substitutes capital for labor, then some labor is unemployed, but the remaining labor is more productive (higher effective capital to labor ratio) and earns a higher wage (VMP = W).

Who gains from increased productivity? The competitive firm passes on the cost savings to the consumers through lower prices. The rise in consumer buying power and the higher incomes of those remaining employees increase the overall demand for goods and services in the economy.

What happens to the level of employment? Because most firms are experiencing increased demand for their goods and services, the price facing firms in these markets rises. The result is that the value of marginal product for labor in those markets increases with output, increasing the overall demand for labor in the labor market.

2.

Why do college graduates earn, on average, so much more than non-graduates? Part of the benefits of earning a degree in higher education is that the graduate has acquired additional critical thinking skills that make him or her much more productive (better able to contribute towards making goods and services that the rest of society values more highly than those goods and services that non-graduates can make). The existence of a significant wage differential between these two groups of people over time is contributing evidence that a college education is a good signal to employers of a value of marginal product of .

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labor. Looking at the unemployment rates for those with a college education versus those without a college education as we have gone through the financial crisis and the recession will bring this home even more than wages.

3.

Do union actions impose the costs of increased labor benefits onto the consumer? Ask the students to identify the opportunity cost associated with employment levels and wage rates in unionized labor markets.

• Emphasize that labor unions try to raise demand for their labor by appealing to governments to raise import quotas on foreign goods and services and to restrict immigration of labor. All of these activities are aimed at increasing the wages paid to union laborers through increasing the price of the goods and services produced by union labor. This increases their value of marginal product and the wage the firm is willing to pay.

• If the firm is a perfectly competitive firm, then the increase in labor costs leads some firms to exit the industry, and the equilibrium market price that consumers must pay for the goods and services rises and both producer surplus and consumer surplus decrease.

• You can make the point that unions are similar to monopolies in that both violate Adam Smith’s “Invisible Hand” idea. In particular, for both unions and monopolies, people looking out for only their self-interest take actions that harm society. So for both unions and monopolies, decisions made in the private interest do not further the social interest.

•

4.

You might look at General Motors or Ford pre-financial crisis and the concessions that unions made to change the costs of care production.

Why do unions support the minimum wage? Union members earn much more than the minimum wage, so why do unions support the minimum wage? The answer is that low-skill labor that earns the minimum wage and high-skill union labor are substitutes. A rise in the minimum wage induces a substitution effect—a decrease in the quantity of low-skilled labor demanded, and an increase in the demand for union labor. With an increase in demand for union labor, the wage rate of union labor rises.

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C h a p t e r

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ECONOMIC INEQUALITY

The Big Picture Where we have been: Chapter 18 explained how factor markets allocate income based on demand and supply for land, capital, and labor. Chapter 19 examines how the factor market outcomes influence the distribution of income and wealth in society. This chapter explains how we measure the degree of inequality, the characteristics of households at different places in the distribution, trends in inequality, and redistribution policies. A theme of the chapter is the role played by human capital and the resulting increase in productivity in affecting the distribution of income.

Where we are going: The following chapter is the last of the microeconomic theory chapters. It focuses on risk and uncertainty and market efficiency in the face of uncertainty.

New in the Thirteenth Edition The introduction to the chapter has been updated to focus on the widening gap between rich and poor. The final Economics in the News analyzes the increasing difference between the incomes of households at the top and bottom of the income distribution. It considers the role technology plays in causing that change.

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Lecture Notes

Economic Inequality • • • •

I.

Incomes are distributed unequally.

In large part, features of the labor market account for the unequal distribution of income.

Other factors also affect income inequality.

The government has policies that redistribute income.

Economic Inequality in the United States •

Money income equals market income plus cash payments to households by the government.

Market income equals wages, interest, rent, and profit earned in factor markets before paying income taxes. In the United States in 2016, the median money income was $59,036, and the mean money income was $83,143.

Where are you in the income distribution? Ask the students to place themselves in the U.S. income distribution by estimating their household income. Be sure to remind them to add together the income of both of their parents if they live with both and both earn income. Many students will be surprised that they are from upper-middle income families, even if they suspected that they were middle income to lower middle income families.

The Distribution of Income •

The distribution of money income in the United States is positively skewed, so that the distribution of incomes has a long tail of high income households. In 2016, • the poorest 20 percent of households received 3.1 percent of total income • the middle 20 percent of households received 14.3 percent of total income • the richest 20 percent of households received 51.2 percent of total income.

The Income Lorenz Curve • •

An income Lorenz curve graphs the cumulative percentage of income earned against the cumulative percentage of households.

The table below has the (approximate) income shares for the United States and the figure graphs the resulting Lorenz curve.

Households (percentage) Lowest 20 Second 20 Middle 20 Next highest 20 Highest 20 •

Income (percentage ) 3 9 15 23

Income (cumulative percentage) 3 12 27 50

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The “Line of Equality” shows what the distribution of income would be if incomes were equally distributed. The closer the Lorenz curve to the line of equality, the more equal is the distribution of income and the farther away the Lorenz curve from the line of equality, the less equal is the distribution of income. .

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Interpreting the Lorenz curve. Emphasize that the Lorenz curve measures economic equality within a given population. Ask: which is more unequal, the distribution of income in the United States or the distribution of income among the 849 major league baseball players? After a minute or two of discussion, you can provide the data in the table below. Make the point that although income is much more unequally distributed among major league baseball players, in 2016 the poorest earned $507,500 a year, which is more than twice the average of the fifth quintile in the United States, $202,000. Relate this reality to a comparison of countries to the United States. Get the students to consider the fact that the average income person living in the poorest quintile in the United States is still enjoying a higher level of income than the median income individual living in any of a majority of other countries around the world.

Quintile U.S. Households Major league baseball players percentage of income percentage of income Lowest 3.1 1.8 Second 8.2 2.8 Middle 14.3 8.2 Fourth 23.2 24.0 Highest 51.2 63.3

The Distribution of Wealth •

Wealth is the value of all the things that are owned by a household at a given point in time. The distribution of wealth can be examined with a Lorenz Curve. Because human capital is not included in measured wealth, the distribution of wealth is more unequal than the distribution of income and the income distribution is a more accurate measure of economic inequality.

Annual or Lifetime Distribution of Wealth?

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Household income varies over the life cycle, typically starting out low, growing to a peak at retirement, and then falling after retirement. Wealth follows a similar pattern.

Inequality in annual income and wealth data overstates life time inequality because households are at different stages in their life cycles.

Trends in Inequality •

The Gini ratio is based on the Lorenz curve and equals the ratio of the area between the line of equality and the Lorenz curve to the entire area beneath the line of equality. The larger the Gini ratio, the more unequal the distribution. The Gini ratio shows that since 1970 the distribution of income in the United States has become less equal.

Economics In Action considers the growing inequality of U.S. incomes. It notes the steady increase in income share for the richest Americans. In 2012 67 percent of Americans surveyed said that incomes were too unequal when in 1991 only 21 percent said this. The Economics in Action feature also presents data on the impact of education, type of household, age, race, and region on incomes.

Poverty •

Poverty is a situation in which a household’s income is too low to be able to buy the quantities of food, shelter, and clothing that are deemed necessary. In 2016, the poverty level calculated by the Social Security Administration for a four-person family was $24,424.

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In 2016, 41 million Americans, 12.5 percent of the population, lived below the poverty level.

• Race: In 2016, 11 percent of white Americans lived in poverty compared to 19 percent of Hispanic-origin Americans and 22 percent of black Americans.

• Age: Poverty rates are 18 percent for children and 9 percent for seniors over age 65.

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• • •

Work Experience: The poverty rate for those with jobs is 6 percent or for those without 31 percent.

Physical Ability: 26 percent of people with disabilities are poor.

Household Status: 27 percent of households headed by women with no husbands present experience poverty.

The Economics in Action considers whether the American Dream is still alive. It uses data to examine mobility up and down the income distribution. The analysis concludes that between 2007 and 2009 most households did not move from one quintile to the next. But there is still mobility, to both higher and lower quintiles.

II. Inequality in the World Economy Income Distribution in Selected Countries •

Countries such as Brazil and South Africa have more unequally distributed incomes, with the average person in the highest quintile receiving 32.5 times the income of the average person in the lowest quintile. The United States lie somewhere in the middle globally, with the average person in the highest quintile receiving 9 times the income of the average person in the lowest quintile.

Finland and Sweden have more equally distributed incomes, with the average person in the highest quintile receiving 4.4 times the income of the average person in the lowest quintile.

• Brazil and South Africa are somewhat extreme and have relatively small and rich European populations and relatively large and poor indigenous populations.

• Finland and Sweden are also somewhat extreme, but less unusual. They are similar in income distribution to many European countries where governments pursue aggressive income redistribution policies.

Global Inequality and Its Trends • • • •

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The global distribution of wealth is much more unequal than the distribution within any one country.

Many nations are still pre-industrial and very poor, while others are sophisticated industrial producers and accordingly quite rich.

3 billion people or 50 percent of the world’s population live on $2.50 per day or less. 2 billion people or 30 percent of the world’s population live on more than $2.50 and less than $10 per day.

That means 5 billion people or 80 percent of the world’s population live on $10 per day or less.

An average person in the United States has an income of $115 per day. The average person in the highest quintile in the industrialized countries has $460 per day. The average American earns 46 times the income of half the world’s population and 11.5 times the income of 80 percent of the world’s population.

The world Gini ratio in 2009 is about .61. The U.S. Gini ratio is about .47. These Gini ratios mean the world’s Lorenz curve lies much farther to the right (away from the line of equality) than the U.S. curve.

Over time, incomes have become more unequal in the United States and the same trend can be found in most economies. But while incomes are more unequal within countries, the world distribution of income as a whole is becoming less unequal. The average incomes in poor countries are rising faster than the average incomes in rich countries, narrowing the gap across countries.

Is capitalism heartless? Emphasize that there are no societies where income or wealth is equally distributed. Society has two main concerns: prosperity and equality. Private enterprise (capitalist) societies are, in general, more prosperous, and in most cases (but not all) have no less equal an income distribution than socialist societies. Ask which is better for a family, to be the poorest in a rich but unequal society or equal with everyone else in a poor society.

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III. The Sources of Economic Inequality Human Capital

In labor markets, differences in human capital as well as discrimination can lead to differences in incomes.

• In general, people with more human capital are high-skilled workers. Skills affect both the demand and supply side of the labor market: • High-skilled workers have a larger VMP than low-skilled workers, so the demand for highskilled workers exceeds the demand for low-skilled workers.

• High-skilled workers must incur the cost of acquiring their skills, so the supply of high-skilled workers is less than the supply of low-skilled workers.

• As the figure shows, the combination of higher demand (DH compared to DL) and lower supply (SH compared to SL) for high-skilled workers versus low-skilled workers leads to a higher wage rate for high-skilled workers.

• The wage differential between high-skilled and low-skilled workers has widened over time because technological changes and globalization have increased the demand for high-skilled workers and decreased the demand for low-skilled workers.

(Technological change has been a complement for high-skilled workers and substitute for low-skilled workers.)

Discrimination •

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Discrimination is another possible source of income inequality. The VMP of the group being discriminated against is less than the VMP of the other group, so discrimination can lower the wage rate of the group being discriminated against. Economists disagree to the extent that discrimination actually affects wage rates.

One line of reasoning states that those firms that practice discrimination face higher costs than those firms that do not. As a result, the profits of the discriminating firms will be lower and the market price of their goods and services will be higher so that these firms cannot survive in competitive markets.

How much workers choose to specialize primarily in a career versus spending more time and energy on home life affects wages. This factor explains part of the wage gap between married men and other types of workers. When the wages of never married men and never married women with the same amount of human capital were compared, wages of the two groups were the same.

Contests Among Superstars • • •

Some of the really large differences in wages cannot be accounted for by differences in human capital. Contests among superstars can explain this difference.

Contests with prizes do a good job of allocating scarce resources efficiently when the efforts of participants are hard to monitor and reward directly. This describes the case for CEOs and other stars.

The prizes are so different because they need to induce enough effort.

• In sports, globalization has increased the total revenue generated by sports. The total prize money has increased and, to generate enough effort amongst all the players, the share going to winner has increased.

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In business, more businesses are global in nature so the number of executives vying for the top positions has increased. To generate enough effort amongst all the executives, the salary paid the CEO—the “winner” of the “contest”—has increased.

What demographic characteristics are correlated with household income? List the demographic characteristics that tend to be correlated with household income: level of education, size of household, and marital status, for example. These result from individual choices and not from characteristics outside the individual’s control (age or race). Emphasize that not all who are living in the lowest (or highest) income quintile will remain in that same economic situation in the long term. Emphasize that private enterprise democracies create dynamic socio-economic pathways for their citizens. Investing in human capital today (deferring current consumption) ensures a much more prosperous life for tomorrow. Advise your students that this investment is much harder to implement after reaching middle age than as a young adult.

Unequal Wealth Greater wealth inequality arises from two sources: life cycle saving patterns and transfers of wealth from one generation to the next.

• Life-Cycle Saving Patterns: Wealth is built over one’s lifetime, so much of the wealth is owned by people in their sixties.

• Intergenerational Transfers: Households that inherit wealth are likely to transfer that wealth to the next generation.

• Marriage and Wealth Concentration: Assortive mating (“like attracts like”) implies that wealthy people seek wealthy partners, so wealth becomes concentrated in a small number of families.

IV. Income Redistribution •

Governments in the United States use three main ways to redistribute income: taxes, income maintenance programs, and subsidized services.

Income Taxes •

All levels of government collect income taxes. Income taxes may be progressive, regressive, or proportional. A progressive income tax is one that taxes income at an average rate that increases with income. A regressive income tax is one that taxes income at an average rate that decreases with income. A proportional income tax (also called a flat income tax) is one that taxes income at a constant average rate, regardless of income.

The U.S. federal income tax is progressive. Ask the students if they think they know the tax burden paid by the richest 1 percent, 5 percent, and 10 percent of taxpayers. The students usually underestimate how progressive the income tax rate system is. IRS figures based on income tax returns collected for the year 2014 reveal that: • The richest 1 percent paid 39.5 percent of all income taxes collected.

• The richest 5 percent paid 60.0 percent of all income taxes collected.

• The richest 10 percent paid 70.9 percent of all income taxes collected.

• The lowest 50 percent paid 2.8 percent of the total income tax collected.

Clearly the progressive nature of the federal tax system redistributes income away from richer households.

Income Maintenance Programs

There are three major types of programs that redistribute income by making direct payments to people in the lower part of the income distribution: • Social security programs: Old Age, Survivors, Disability, and Health Insurance (OASDHI) makes monthly cash payments to retired or disabled workers or their surviving spouses and children. .

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Unemployment compensation: Every state government has established an unemployment compensation program that taxes all workers in the state and gives unemployed workers in the state a periodic cash benefit for a specified period of time.

Welfare programs: Welfare programs provide incomes for people with incomes below a specified level and who do not qualify for social security or unemployment programs. These programs include the Supplementary Security Income (SSI) program, the Temporary Assistance for Needy Households (TANF) program, the Food Stamp program, and Medicaid.

Subsidized Services •

A great deal of income redistribution takes place in the United States through the provision of subsidized services, services provided by the government at prices below the cost of production.

Examples include primary and secondary public education, as well as state colleges and universities. Medicare and Medicaid are other examples of subsidized services.

An Economics in Action feature presents data that shows how government taxes and benefit programs redistribute income and make the distribution more equal.

The Big Tradeoff •

Redistributing income leads to a tradeoff between equity and efficiency, known as the big tradeoff. Programs to redistribute income lead to inefficiency because the process of income redistribution uses up resources and, more importantly, because redistribution decreases the incentives for the taxpaying workers to provide labor and decreases the incentives for the benefit recipients to provide labor.

What are the costs of redistributing income? Emphasize that there is an opportunity cost to redistributing income in any society: when a dollar is taken from a rich person, a poor person receives less than a dollar. The size of the economic pie shrinks because: • Productive resources are consumed to implement the program rather than produce goods and services, • Redistribution requires taxation of income or exchange, which imposes a dead weight loss to society, and • The incentives facing the recipient of supplemental income are altered, delaying re-entry into the work force.

Economics in the News: America’s Rich Get Richer and the Poor Get Replaced by Robots reports on the rising gap etween the top income households and the bottom income houses and the role that technological change in the labor market plays. It concludes that the effects on income are pronounced in high-tech hubs.

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Additional Problems 1.

How does the minimum wage affect the distribution of income?

2.

Compared to the United States, managers in Hong Kong and Malaysia are paid much more than the low-skilled factory workers that they supervise. What accounts for this difference in relative pay?

3.

Many pets in rich nations eat better than people in poor nations. To equalize the international distribution of income, do you think that rich nations should tax their citizens and give the income to the poor of very poor nations? Would this policy be fair?

Solutions to Additional Problems 1.

The minimum wage affects the distribution of income in several ways. First, workers who without the minimum wage would be paid less, receive a higher income than otherwise with the minimum wage. Because these workers are low-income workers, the minimum wage makes the distribution of income a bit more equal. Second, some workers lose their jobs when a minimum wage is imposed.

These workers’ incomes fall and the minimum wage makes the distribution of income less equal.

Finally, the minimum wage probably decreases some firms’ profits and so decreases their owners’ incomes. Because owners are generally higher-income earners, the minimum wage makes the distribution of income more equal.

2.

The difference in pay is a result of the fact that managerial skills are in much smaller supply in Hong Kong and Malaysia. There are many low-skilled factory floor workers in Hong Kong and Malaysia.

There are few high-skilled managers. As a result, the equilibrium wage rate paid to the few highskilled managers in Hong Kong and Malaysia is many times greater than the wage rate paid to the many low-skilled factory floor workers.

3.

It is indeed the case that people in rich nations are much better off than people in poor nations. Rich nations are better off because their citizens are more productive because they have immensely greater amounts of physical and human capital. The question of redistributing income from one nation to another has a big tradeoff associated with it. In particular, while the transfer of income to poorer nations equalizes income among nations, it lessens the poor nations’ incentives to develop and so slows their economic growth. In addition, the issue of fairness comes into play. The “fair results” approach to fairness argues that it is definitely fair to transfer resources to poor nations. But the “fair rules” approach to fairness suggests that these transfers aren’t fair. Taking tax revenue from people in rich nations to transfer the funds to poor nations is not a voluntary exchange and so is unfair.

Additional Discussion Questions 1.

What is the difference between poverty and an unequal income distribution? Ask the students to consider each of these measures of economic inequality by asking the following set of questions: How would you define poverty? Get the students to realize that poverty is a relative measure, rather than a positive measure of economic inequality. The minimum quantity of food, clothing, and shelter to a U.S. student is likely to be considered as abundant riches to the average citizen of developing countries.

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Does an unequal income distribution imply that poverty exists? Does poverty imply that an unequal income distribution exists? The upper-income people in some developing countries have annual incomes that are less than the monthly income of the typical unskilled laborer living in the U.S. Because poverty is a relative measure, there is little direct relationship between unequal income distribution and the incidence of poverty.

Is it necessarily a bad thing for the Gini Ratio to increase over time? Ask the students what the implications are for a society in which: 1) workers are rewarded based on merit, 2) most workers make good decisions over their lifetime, (invest in human capital, maintain a good work ethic, etc.) some workers make bad decisions (drop out of school, waste their life on drugs, crime, etc.), and 3) those that make good decisions in life become more productive and earn higher wages than those that make bad decisions in life. Point out that even in a “perfect world” where race or gender discrimination was completely absent, and no “bad luck” situations were to ever affect anyone, the Gini Ratio would still increase over time as this merit-based economy continues to reward those who make good decisions more highly than those who make bad decisions. This implies that an increasing Gini Ratio is not necessarily a bad indicator for those concerned about equity as well as efficiency.

2.

If you were a benevolent dictator, how would you deal with the Big Tradeoff? Ask the students to choose a degree of economic inequality they think should be the maximum that our society must endure (in terms of lost efficiency). Have them justify this level of economic inequality by using the economic concepts of marginal benefit and marginal costs: How would you measure the marginal cost to society of an unequal income distribution? Point out that before we embark on a program to rectify the problem of economic inequality, we first must assess the degree of the problem: How should we measure the social cost of unequal economic opportunities? Many economic studies have attempted to do this, but without much success in gaining wide acceptance of the methodology.

How would you measure the marginal cost to society of implementing an income redistribution program? Once we are comfortable with our measure of the social cost of economic inequality, we turn to the alternative: What amount of prosperity would we all be willing to give up as a society to increase economic equality in our society (how much smaller would we want the economic pie to be)? More importantly, what cost would we be willing to impose on others in society to rectify economic inequality? How should this decision be made? Help the students to see how complex the issue of economic inequality really is in the world. There are no simple solutions.

3.

If two different but equally “important” occupations in society were to earn very different levels of income, is this necessarily reflective of discrimination? Remind students that while it is true that firms’ demand for labor is partially derived from society’s demand for the product generated from the occupation’s labor force, the wages that firms pay for that labor is also determined by the households’ willingness to supply labor to that occupation. Much of the observed differences in wages across equally “important” occupations can be attributed to the relative unwillingness of households to supply as much labor for the higher paid occupation as for the lower paid occupation. This is a different reality than assuming that firms’ are largely unwilling to pay a wage equal to the value of the true VMP of labor to a certain class of laborers that tend to dominate the lower paid occupations.

4. Are prizes on shows like American Idol unfair? Discuss whether the unevenness in the rewards for shows induces more effort or are unfair.

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5. Are there fewer women CEOs and do women CEOs make lower wages because they are not giving enough to their careers as they try to maintain family responsibilities?

Recently the CFO of Facebook wrote a book that garnered a lot of press and sparked conversation about what women need to be giving to the labor market to succeed.

Supportive and critical opinion pieces on this topic are widely available and might spark a good classroom conversation.

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20

UNCERTAINTY AND INFORMATION

The Big Picture Where we have been: Chapter 20 uses the general economic reasoning featured in many of the previous chapters.

For instance, Chapter 20 uses the concepts of marginal utility first covered in Chapter 8. It concludes with a general discussion of efficiency in information markets, which draws upon material first covered in Chapter 2 and expanded upon in Chapter 5.

Where we are going: Chapter 20 is the final chapter in the microeconomics section. This chapter is important because it relaxes many of the implicit assumptions concerning information that bother students about the efficiency of the market. Chapter 20 provides some interesting, real-life examples of market processes in an uncertain world.

New in the Thirteenth Edition The chapter has been lightly revised to help enhance students’ understanding. The ending Economics in the News case on grade inflation has been updated.

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Lecture Notes

Uncertainty and Information • • • •

I.

People need to make decisions in the face of uncertainty and risk.

Markets allow people to buy and sell risk.

Some people may have private information.

Markets must cope with incomplete information, which can lead to moral hazard and adverse selection.

Decisions in the Face of Uncertainty

Expected wealth • •

Expected wealth is the money value of what a person expects to own at a given point in time.

An expectation is an average calculated by using a formula that weights each possible outcome with a probability (chance) that it will occur.

Risk aversion •

Risk aversion is the dislike of risk. Most people are risk averse.

Utility of Wealth •

Wealth yields utility, but the marginal utility of wealth diminishes as wealth increases, as shown in the figure. Because the slope of the utility of wealth curve diminishes as wealth increases, the utility gained from a $1 increase in wealth is less than the utility lost from a $1 decrease in wealth.

Expected utility •

This is the utility value of what a person expects to own at a given point in time. It is calculated by using a formula that weights each possible outcome with the probability that it will occur.

• In the figure, suppose a person is faced with two investments: One offers wealth of $26,000 with no uncertainty and so has utility of 40 units with no uncertainty. The other option has, with a 0.50 probability, wealth equal to $40,000 and utility of 50 units; or, with another 0.50 probability, it has wealth of $20,000 and utility of 30 units. Expected utility from this second option is 0.50  50 units + 0.50  30 units = 40 units. If given the choice between $26,000 with certainty and a 50:50 chance of having $40,000 or $20,000, the person is indifferent between the two choices because both have the same (expected) utility, 40 units.

• The expected wealth from the second option is 0.50  $40,000 + 0.50  $20,000 = $30,000, which is $4,000 more than the certain wealth of $26,000 from the first option. The $4,000 difference is called the cost of risk.

Making a Choice with Uncertainty • •

Faced with uncertainty, people choose the option with the highest expected utility.

By comparing the expected utility from a risky prospect with the expected utility from a safe prospect, you can choose the one that maximizes expected utility.

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II. Buying and Selling Risk Both buyers and sellers gain from exchanging risk as they would any product. What they are trading is avoiding risk. A buyer of risk avoidance is transferring the risk to the seller. The seller is willing to assume the risk because the costs of risk are lower to the seller than what the buyer is willing to pay.

Insurance Markets • • •

How insurance reduces risk: People pool and share risk. When people buy insurance against the risk of an unwanted event, they pay an insurance company a premium. If the unwanted event occurs, the insurance company pays out the amount to the insured.

Why people buy insurance: People buy insurance because they are risk averse. If premiums are not too high, loss of utility from paying the premium for the insurance is less than the expected utility loss if the adverse event were to occur.

How insurance companies earn a profit: • Everyone pays into the insurance pool, but only the small fraction of people who actually suffer a loss are paid from these funds.

• Although the probability of any particular individual suffering a loss is quite small, for a large number of people the total number and the total amount of losses can be estimated very accurately.

• Insurance companies earn a profit because the insurance company can collect a premium that is high enough to at least break even, and customers who are risk averse are willing to pay that premium.

A Graphical Analysis of Insurance •

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Risk Taking Without Insurance: In the figure, suppose the person has a 50 percent chance of keeping $40,000 of wealth and a 50 percent chance of having $20,000 of wealth. As seen before, the expected wealth is $30,000 and the expected utility is 40. The figure shows that the person is willing to accept a lower wealth with certainty, $26,000, which will give the same utility, 40, as the risky case.

The Value and Cost of Insurance: The key point is that the certain wealth with utility of 40 ($26,000) is less than the expected wealth with utility of 40 ($30,000). As long as the person can buy insurance for less than $14,000, the individual is better off (has higher expected utility) from the purchase of insurance than from the uncertainty of wealth with no insurance.

Ignoring any operating costs, if there are many people in the same situation the insurance will cost the insurance company $10,000 per person, the expected loss per person. As long as the company can sell the insurance for more than $10,000, the insurance company is better off by selling the insurance.

Gains from Trade: Both the insurance company and the person will be better off if insurance can be bought and sold for between $14,000 and $10,000.

Why are men (especially young men) charged more for auto insurance? Have the students consider the difficulty of providing insurance with affordable premiums to consumers, yet be profitable enough to encourage producers to accept the risks involved. For example, car insurance companies charge higher .

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premiums to unmarried young men than they charge unmarried young women, even if two such individuals have the same driving records. This difference is based on statistical probabilities calculated by the insurance company keeping record of large samples of loss claims. Ask the students if this difference is “fair?” Then ask how a drivers’ risk-taking behavior might change once he or she is insured. This last question is a good introduction to the following material on private information and moral hazard.

Risk That Can’t Be Insured • •

If risks are not independent, they cannot be insured (e.g., private markets will not insure homeowners in a flood plain because the occurrence of a flood negatively affects everyone in that area).

Risks must be observable to both the buyer and the seller in order to be insurable.

Economics in Action considers insurance in the United States, both private and public such as Medicare, Social Security, and unemployment insurance.

III. Private Information Asymmetric Information: Examples and Problems • •

Private information is information about the value of the item being traded that is possessed by only buyers or sellers. A market in which buyers or sellers have private information has asymmetric information.

Asymmetric information creates two problems: • Adverse selection is the tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party.

• Moral hazard is the tendency for people with private information, after entering into an agreement, to use that information for their own benefit and at the cost of the less-informed party.

The Market for Used Cars • • • •

The owner of a used car has private information about the quality of the car. If the buyer cannot determine the quality of the car before the purchase, moral hazard occurs when the seller claims that each car is high quality but in truth offers “lemons” for sale.

Because consumers are unable to distinguish between a “lemon” and a good vehicle, they must assume that all used vehicles for sale are “lemons,” and used car dealers must price their cars at the highest price that consumers will pay for a “lemon.”

The problem that in markets in which it is not possible to distinguish reliable products from lemons, there are too many lemons and too few reliable products traded is called the lemons problem.

However, used car dealers can overcome the lemon problem by offering a warranty on the vehicle, which is a signal that the car is of high quality. Signaling occurs when an informed person takes actions that send information to uninformed persons.

• An equilibrium in a market when only one message is available and an uninformed person cannot determine quality (as with the market for lemons) is called a pooling equilibrium.

• An equilibrium when signaling provides full information to a previously uninformed person (as in the used car market with warranties) is called a separating equilibrium.

The Market for Loans •

Some borrowers are low risk, and will likely repay their loans, and others are high risk, and will likely default on their loans. The risk that a borrower might not repay a loan is called credit risk or default risk. Banks want to charge low-risk borrowers a low interest rate and high-risk borrowers .

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a high interest rate, but banks cannot immediately distinguish between the two classes of borrowers.

If banks cannot charge different interest rates to different individuals with varying default risks, the result is an inefficient pooling equilibrium.

• Banks use signals, such as length of time on the job, marital status, age, and other factors correlated with low-risk borrowers to try to determine the risk of loaning funds to each individual borrower. Borrowers may have an incentive to mislead lenders, so banks often require that borrowers provide relevant information about the likelihood the loan will be repaid (salary, wealth, tenure on the job, for example). Inducing an informed party to reveal private information is called screening.

An Economics in Action examines the sub-prime credit crisis. Prior to the crisis the supply of funds to the sub-prime market was much greater than during the crisis.

The Market for Insurance •

Moral hazard occurs when insured people have less incentive to be careful and avoid risky behavior. And adverse selection arises because people who create greater risks are more likely to buy insurance.

• Insurance companies seek out signals (such as an auto insurer looking at an individual’s driving record) to limit the extent of the adverse selection problem.

• Deductibles, where the insured person also must pay part of the expense of an incident, can reduce the moral hazard problem.

Moral hazard in game shows. The television show, “Who Wants to Be a Millionaire?” was insured by an insurance company that reimbursed the producers of the show when a contestant answered all the questions correctly and won a big dollar pay-out. This insurer had some serious disagreements with the show’s producers after the show ran on national television for the first year, claiming concerns over moral hazard. In particular, the insurer claimed that the producer eased the questions asked of the contestants in order to guarantee that some contestants won and thereby boosted the show’s excitement and ratings.

The insurer wanted greater control over the difficulty of the questions being asked of the contestants.

IV. Uncertainty, Information and the Invisible Hand Information as a Good • •

Obtaining more information has increasing opportunity costs and consuming more information has decreasing marginal benefits.

The efficient amount of information is the amount at which the marginal benefit from information equals the marginal cost. It is hard to determine whether a competitive market for information would produce it at the efficient level.

Monopoly in Markets that Cope with Uncertainty • •

Large economies of scale probably exist is providing services to reduce uncertainty and to provide better information. Therefore insurance markets are highly concentrated.

Monopoly leads to inefficient results, even in the absence of uncertainty, so underproduction of information is thus likely.

Economics in the News considers the case of grade inflation. Grade inflation makes it more difficult for employers to determine who is outstanding and who is not.

.

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Additional Problem 1.

How might adverse selection discourage firms from underpaying their workers?

2.

How might moral hazard discourage firms from offering workers a fixed wage?

3.

Baseball players often seek contracts with a “no-trade” clause so that the player cannot be traded from his current team without his permission. a. Provide an example of private information that a baseball player who wants a no-trade clause possesses. b. Does a baseball player with a no-trade clause present a moral hazard to his baseball team? c. Does a baseball player with a no-trade clause present adverse selection problems to his baseball team?

4.

How does health insurance and flood insurance result in both a moral hazard and adverse selection problem?

5.

How do insurance companies use premiums and deductibles in an attempt to resolve these problems?

Solutions to Additional Problems 1.

If a firm gets the reputation for underpaying its workers, only low quality workers will apply to work at the firm, thereby presenting the firm with a severe adverse selection problem.

2.

If firms offer workers a fixed wage regardless of their effort workers have the incentive to shirk, that is, to work less hard than otherwise.

3.

a. b.

c.

A player could know that he was injured or that he had not healed as well as possible from an injury.

A player with a no-trade clause presents a moral hazard problem. The player can claim to be more badly injured than is truly the case to avoid playing some games. The player can make this claim knowing that even if he often does so, his team cannot trade him and must continue to pay his salary.

If there are two types of contracts—contracts with the no-trade clause and contracts without it— then there is a potential adverse selection problem. Players who know they are more inclined to want to skip a game or two will be eager to sign a no-trade contract because this contract lessens their cost of feigning injury to take leisure.

4.

Health and flood insurance both present moral hazard and adverse selection problems. Adverse selection is present because less healthy people will be more likely to buy health insurance and people living in flood prone areas will be more likely to buy flood insurance. Moral hazard is present because people with health insurance become more prone to take risks and people with flood insurance become less prone to build flood resistant structures.

5.

Insurance companies use premiums and deductibles in an effort to create a separating equilibrium.

The companies offer policies with high deductibles and low premiums to attract low-risk customers, that is people who are not likely to be susceptible to diseases or people who have not built in a flood plain. Simultaneously the companies also offer policies with high premiums and low deductibles to appeal to high-risk customers, that is people who are prone to contracting certain ailments or who have built in a flood plain. .

UNCERTAINTY AND INFORMATION

225

Additional Discussion Questions 11. What does being risk averse mean? Get the students to consider why a risk premium must be paid to overcome the consumer’s cost of risk.

12. Why do people prefer the utility arising from a level of income known with certainty more than the utility arising from the same value of expected income arising from a risky choice? Get the students to understand that the consumer will never achieve the expected level of income arising from a risky decision when confronted with a single choice.

Expected income is the value of income that is averaged over numerous outcomes under the same circumstances. For any one point in time, knowing utility from a given outcome is preferred to the expected utility of a risky outcome, despite the two having the same expected level of income.

13. Would insurance companies prefer a higher or lower degree of risk aversion among consumers? Point out to students that the more concave the utility of wealth schedule, the higher the cost of risk, and the greater the risk premium that the consumer is willing to pay to avoid risk.

14. Why will private insurance companies sell health insurance that pays for unexpected illness but not unemployment insurance that pays for unexpected unemployment?

Explain that adverse selection motivates high risk workers who know they are likely to be laid off will be willing to pay a high risk premium for unemployment insurance, but low risk workers who know they are unlikely to be laid off will only pay a low risk premium. By offering insurance premiums that are desirable to the low risk workers, high risk workers will buy the insurance as well, preventing the insurance companies from knowing which workers are high risk and which are low risk. This burden on insurance carriers is not as evident in offering health insurance because the insurers can seek out signals from consumers which reveal who has low-risk lifestyle and who have a high-risk lifestyle (such as determining whether the potential health insurance customer is a smoker, or is older, or is overweight, etc.)

15. What are some examples of goods that require “information” for consumers to enjoy and goods that require “private information”? All goods require consumers to have access to price and availability information. However, private information relates to goods that consumers cannot completely understand until they commit to purchasing the good.

Goods in this category include used cars, long-wearing and comfortable shoes, high-end consumer electronics, good homes in pleasant neighborhoods, etc. Markets for these goods typically create opportunities for middlemen (like realtors, retailers and car dealers) to supply advice and match consumer tastes with producer goods.

16. Is the use of signals to discern between high and low risk consumers “fair”? Ask the students whether charging 17-year-old, unmarried males higher auto insurance premiums than 35-year-old, unmarried females “fair”? Is it “fair” for individuals with pre-existing health conditions to pay higher insurance bills? Is it “fair” for employers to pay women less because women are (obviously) more likely to give birth? On the other hand, is the use of signals “efficient”? Get the students to consider the tradeoff between pooling risk (making avoiding risk affordable) and avoiding moral hazard (making careful, thoughtful consumers pay for the mistakes of careless, thoughtless consumers).

7.

Health care reform uses “pools” of individuals to help to reduce health care costs for those currently without insurance. How is this intended to help and why was it designed so people could not “opt out” of having insurance? The larger the pool, the more risk is .

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spread out. If younger, healthier workers less likely to have claims can avoid participation, the expected outlays for the insurance company are spread across a smaller pool, risk rises for the insurance company, and customers have to pay higher premiums.

.

C h a p t e r

4

MEASURING GDP AND ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 4 does not directly use the material developed in the previous chapters.

Where we are going: Chapter 4 is the first of the macroeconomic chapters. It provides some basic definitions (GDP, real GDP, aggregate expenditure, potential GDP, and business cycles) that are used in virtually all the remaining chapters. The circular flow model and the national income accounting explained in this chapter serve as a general framework for macroeconomic analysis. The figures that show that aggregate expenditure equals aggregate income which all equals the value of production is the key to understanding why changes in aggregate expenditure feed back into aggregate income, which in-turn then feeds back into aggregate expenditure. The components of aggregate expenditure provide an underpinning for the theory of aggregate demand in Chapter 10 and the aggregate expenditure model and multiplier in Chapter 11. In these later chapters, the multiplier effect will be challenged by showing how inflation, imports and taxes dampen its size and potentially eliminate it all together.

New in the Thirteenth Edition The content within the chapter is substantially the same as the 12th edition. All of the data within the chapter have been updated to use 2016 data. The current event topic is under the ‘Economics in the News’ section and discusses the continued slow growth in the United States through the first half of 2017.

*

* This is Chapter 21 in Economics. .

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Lecture Notes

Measuring GDP and Economic Growth • • •

I.

GDP is a measure of total production and total income.

Real GDP measures production of goods and services.

GDP can be used to make comparisons over time and across countries.

Gross Domestic Product •

GDP or gross domestic product is the market value of all the final goods and services produced within a country in a given time period.

How do you add apples and oranges? You can pick any goods you like but I think it is helpful to show GDP as an equation early on. You can start with real goods and then generalize to “n goods”: GDP = PAQA + POQO + …

GDP = P1Q1 + P2Q2 + P3Q3 + … + PNQN GDP = ∑ PiQi You may find it useful to add slang while you discuss GDP, “GDP is the dollar value of all ‘stuff’ made over one year.” Be sure to repeat the definition as you move through all the chapters rather than assuming your students always remember what is in GDP and how it is measured. A solid understanding of GDP is crucial for other material to make sense.

•

• • • •

The items in GDP are valued at their market values, that is, at their prices. So if 100,000,000 slices of pizza are sold for $3 each, slices of pizza contribute $300,000,000 to GDP. Using market values means that the total value of output, that is, GDP will be in the dollars (or whatever the country’s currency unit might be).

A final good is an item that is bought by its final user. It contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service.

To avoid double counting, GDP includes only final goods and services (no intermediate goods and services are directly counted).

Only the goods and services produced within a country are counted. A Honda produced in North Carolina is counted in U.S. GDP. GDP is measured over a period of time, typically a quarter of a year or a year.

Gross Domestic Product. The main challenge in teaching this topic is generating interest in it. Many teachers are bored by it and not surprisingly, they bore their students. If you are one of the many who lean toward boredom, start by recalling just how vital it is that we measure the value of production with reasonable accuracy. Working through issues with GDP is vital since it serves as the basis of measurement of the standard of living, economic welfare, and making international comparisons.

Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software.

The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in 1999. When the 1996 GDP was recalculated to include software as a final good, GDP increased by $115 billion, or 1.5 percent.

GDP and the Circular Flow of Expenditure and Income •

The circular flow illustrates the equality of income, expenditure, and the value of production. The circular flow diagram shows the transactions among four economic agents—households, firms, .

MEASURING GDP AND ECONOMIC GROWTH

•

39

governments, and the rest of the world—in two aggregate markets—goods markets and factor markets.

In the goods market, households, firms, governments, and foreigners buy goods and services. For analytical purposes, we can categorize spending by these four agents in the calculation of GDP: • The total payment for goods and services by households in the goods markets is consumption expenditure, C. • The purchases of new plants, equipment, and buildings and the additions to inventories are investment, I. • Governments buy goods and services, called government expenditure or G, from firms.

• Firms sell goods and services to the rest of the world, exports or X, and buy goods and services from the rest of the world, imports or M. Exports minus imports are called net exports, X − M.

Government transfer payments, such as Social Security payments, are not part of government expenditures because government expenditures include only funds used by the government to buy goods and services. Transfer payments are not buying a good or service for the government and so are not included in government expenditures.

•

In factor markets households receive income from selling the services of resources to firms. The total income received is aggregate income. It includes wages paid to workers, interest for the use of capital, rent for the use of land and natural resources, and profits paid to entrepreneurs; retained profits can be viewed as part of household income, lent back to firms.

The Circular Flow Model. Start with a simpler picture than Figure 4.1—just households and firms, and just income and consumption. Explain that you are starting from the basics, in which all goods and services produced are sold to consumers. Explain that even beyond the assumption that all goods and services are consumption goods and services, we’re simplifying things in the picture but are not omitting anything that leads us into a misleading conclusion. For instance the picture envisages all the income being paid to households. Nothing is lost and clarity is gained by this device. Emphasize that the blue flows are incomes and the red flows are expenditures on final goods and services. Clearly in this simplest case aggregate income equals aggregate expenditure. Then add investment. It is still the case that aggregate expenditure (which is now C + I) equals aggregate income. Next add the government and the flow of government expenditure. Finally add the rest of the world and the flow of net exports. In both cases you can continue to make the crucial point at aggregate expenditure equals aggregate income.

GDP Equals Expenditure Equals Income •

•

Aggregate expenditure equals C + I + G + (X − M). Aggregate expenditure equals GDP because all the goods and services that are produced are sold to households, firms, governments, or foreigners.

(Goods and services not sold are included in investment as inventories and hence are “sold” to the producing firm.)

Because firms pay out as income everything they receive as revenue from selling goods and services, aggregate income equals aggregate expenditure equals GDP.

Why “Domestic” and Why “Gross”?

•

•

Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence. The total amount spent on purchases of new capital and on replacing depreciated capital is called gross investment. The amount by which the stock of capital increases is net investment. Net investment = Gross investment − Depreciation.

The “Gross” in gross domestic product reflects the fact that the investment in GDP is gross investment and so part of it goes to replace depreciating capital. Net domestic product subtracts depreciation from GDP. .

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II.

Measuring U.S. GDP

Most of the income data used by the BEA to measure GDP come from the IRS. Expenditure data come from a variety of sources.

The Expenditure Approach •

The expenditure approach measures GDP as the sum of consumption expenditure, C, investment, I, government expenditure on goods and services, G, and net exports of goods and services, (X − M).

So GDP = C + I + G + (X − M) or, in 2016 and in billions of dollars, $12,758 + $3,036 + $3,277 + −$502 = $18,569.

The Income Approach •

The income approach measures GDP as the sum of compensation of employees, net interest, rental income, corporate profits, and proprietors’ income. This sum equals net domestic income at factor costs. To obtain GDP, indirect taxes (which are taxes paid by consumers when they buy goods and services) minus subsidies plus depreciation are included. Finally any discrepancy between the expenditure approach and income approach is included in the income approach as “statistical discrepancy.”

Measuring U.S. GDP, the low cost of economic data. You might like to tell your students that measuring real GDP is actually very cheap. The BEA (in the Department of Commerce) employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of the nation’s production. For some further perspective, the National Oceanic and Atmospheric Administration (also in the Department of Commerce), whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion!

Creative accounting and GDP measurement. In recent years, the first estimates of GDP, which are based on companies’ reported profits, have been revised downward when data on company profits as reported to the IRS became available. You can make a nice point with one example of creative accounting. In the past some Internet companies recorded advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services and a charge against profit. Take, for example, Google. The expenditure on Google services is the value of Google’s production. And Google’s expenditure on advertising is part of the value of the production of the advertising agencies used by Google. You can go on to explain that Google’s accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, Google’s advertising expenditure shows up as investment in the national accounts.

On the income approach, because the expenditure is not a cost, it swells profit, so Google’s corporate profit increases by the same amount as its “investment.” If Google filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But if, when Google files its tax returns, it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts are adjusted appropriately.

Nominal GDP and Real GDP • •

The market value of production and hence GDP can increase either because the production of goods and services are higher or because the prices of goods and services are higher.

Real GDP allows the quantities of production to be compared across time. Real GDP is the value of final goods and services produced in a given year when valued at the prices of a reference base year. .

MEASURING GDP AND ECONOMIC GROWTH

•

Nominal GDP is the value of the final goods and services produced in a given year valued at the prices that prevailed in that same year.

41

Data for 2016 Item

Quantity

Price

Market Value

Books

40

$25

$1,000

Coffee

1,000

$2

$2,000

Calculating Real GDP •

•

• •

Nominal GDP $3,000 Traditionally, real GDP is calculated using prices of the Data for 2017 reference base year (the year Item Quantity Price Market Value in which real GDP=nominal Books 50 $30 $1,500 GDP).

Coffee 1,500 $3 $4,500 The tables to the right show this method of calculating real Nominal GDP $6,000 GDP for an economy that produces only books and 2017 Quantities and 2016 Prices coffee. If 2016 is the reference Item Quantity Price Market Value base year, nominal GDP in Books 50 $25 $1,250 2016 in the top table equals real GDP in 2016. Real GDP in Coffee 1500 $2 $3,000 2016 is $3,000.

Real GDP $4,250 The second table shows the (2016 calculation for nominal GDP dollars) in 2017.

Real GDP in 2017 is in the bottom table. It values 2017 production using the prices from the reference base year, 2016. Real GDP in 2017 is $4,250.

You may want to mention the GDP deflator at this point even though coverage of it is in next chapter.

Stress the separation of the “quantity effect,” measured by real GDP, and the “price effect,” measured by the price level. Real GDP will be used to compute the economic growth rate while the price level will be used to compute the inflation rate.

REQUIRES MATHEMATICAL NOTE: Chained-Dollar Real GDP •

• •

The top table to the right has data GDP Data for 2016 for 2016 for an economy that Item Quantity Price Market Value produces only books and coffee. In 2016, nominal GDP is $3,000. The Books 40 $25 $1,000 second table to the right has the Coffee 1,000 $2 $2,000 same data for 2017. (These tables Nominal GDP $3,000 are the same as used above to calculate real GDP using the GDP Data for 2017 standard method.) In 2017, nominal GDP is $6,000.

Item Quantity Price Market Value Nominal GDP has doubled but how Books 50 $30 $1,500 much has real GDP changed Coffee 1,500 $3 $4,500 between these years?

Nominal GDP $6,000 To determine how real GDP changes, suppose that 2016 is the base year. Then we need to determine the growth rate between 2016 and 2017 by calculating the value of production in both years using 2016 prices and also calculating it in both years using 2017 prices. .

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•

Using 2016 prices, the value of production increases from $3,000 (the first table) to $4,250 (the third table). Using 2016 prices, the value of production has grown by 100  ($4,250 − $3,000)/$3,000 = 41.7 percent.

2017 Quantities and 2016 Prices

•

•

Quantity

Price

Market Value

Books

50

$25

$1,250

Coffee

1500

$2

$3,000

Value of production (2016 dollars)

•

Using 2017 prices, real GDP increases from $4,200 (the fourth table) to $6,000 (the second table). Using 2017 prices, the value of production has grown by 100  ($6,000 − $4,200)/$4,200 = 42.9 percent.

Item

$4,250

2016 Quantities and 2017 Prices Item

Quantity

Price

Market Value

Books

40

$30

$1,200

Coffee 1,000 $3 $3,000 The average growth rate is equal Value of $4,200 to (41.7 percent + 42.9 percent)/2 production = 42.3 percent. So real GDP (2017 dollars) between these years has grown by 42.3 percent. If 2016 is the base year, real GDP in 2017 is $3,000  1.423 = $4,269.

Similar calculations are made for each pair of adjacent years from the reference base year onwards. This procedure chains real GDP back to the reference base year.

III. The Uses and Limitations of Real GDP The Standard of Living Over Time • • •

One measure of the standard of living over time is real GDP per person, or real GDP divided by the population. Real GDP per person tells us the value of goods and services that the average person can enjoy.

The value of real GDP when all the economy’s labor, capital, land, and entrepreneurial ability are fully employed is called potential GDP. Potential GDP grows at a steady pace because the quantities of the factors of production and their productivity grow at a steady pace.

The growth rate of real GDP slowed in the productivity growth slowdown after 1970. This slowdown created a Lucas wedge. A Lucas wedge is the dollar value of the accumulated gap between what real GDP per person would have been if the growth rate had persisted and what real GDP per person actually turned out to be.

The Importance of the Lucas Wedge. It is usually straightforward to interest students in the business cycle. But it is perhaps a bit more difficult to motivate interest in economic growth and the Lucas wedge.

Yet economic growth and the Lucas wedge should be of immense importance to young students because they help determine the long-run living standard of their lives. One way to make this point clear is to ask the students whether the difference between, say, 3 percent annual growth in income versus 4 percent annual growth is important. This difference probably does not sound important. But, suppose that the initial income was $35,000. After 10 years with 3 percent growth, the income would be $47,037 and with 4 percent growth the income would be $51,809. This difference of about $4,500 might not seem like much.

But point out to the students that this difference is for only ten years and that the annual difference will continue to enlarge: After 30 years with 3 percent growth, the income would be $84,954 and with 4 percent growth the income would be $113,519, a one year difference of about $40,000. And, over a 30year working career, the total differences in income, which is the analog to the Lucas wedge, is approximately $420,000. Over a 40-year working career, the Lucas wedge difference is over $1,000,000!

Viewed from this perspective, the seemingly slight 1 percentage point difference in growth rates makes for .

MEASURING GDP AND ECONOMIC GROWTH

43

an incredibly major difference in incomes, which should easily capture your students’ attention.

• Fluctuations in the pace of expansion of real GDP is denoted the business cycle, periodic but irregular increases and decreases in the total production and other measures of economic activity.

Each cycle is categorized by: trough, expansion, peak, recession.

The Business Cycle. Students generally are interested in the topic of business cycles, particularly if the economy happens to be in a recession when this chapter is covered. Often it is very difficult to tell the future path of the economy. Stress to the students that it is not stupidity on the part of economists that prevents us from knowing where the economy is heading. Rather it is the fact that forecasting is difficult for at least two reasons. First, different sectors of the economy frequently send different signals. For instance, retail sales may be down, signaling a start to a recession, but housing starts may be up, indicating that an expansion will continue for a while. Second, the data that must be used always are at least a bit outof-date. For example, the preliminary estimate of GDP is not made until approximately six weeks after the end of the quarter, and the final revision of GDP doesn’t appear until years later. Although economists’ forecasts are much better than those of others, forecasting GDP with complete accuracy is unlikely.

Conclude by mentioning that this fact is important in later chapters when we discuss implementation of counter-cyclical policies.

The Business Cycle, Part 2: The business cycle and its dating are interesting to students, especially when the economy is in or near a recession. If you have the capacity to show or assign Web pages, look at the NBER Business Cycle Dating Committee’s page at http://www.nber.org/cycles/recessions.html.

You might like to look at the dating of the cycle in other countries. This dating is done by the Economic Cycle Research Institute (ECRI). You can find their Web site at http://www.businesscycle.com/. Another page on the ECRI Web site shows the cycle peak and trough dates for 18 countries from 1948 nicely aligned in a table.

You can compare the timing of cycles internationally. You can also compare the severity of U.S. cycles over time. Note that the recession that the NBER dates as beginning in March 2001 and ending in November 2001 was incredibly mild on all criteria except the labor market. The “Great Recession” that started in 2007, however, is one of the worst since the great depression.

The Standard of Living Across Countries •

•

Real GDP can be used to compare living standards across countries. But two problems arise in using real GDP to compare living standards: • First, the real GDP of one country must be converted into the same currency unit as the real GDP of the other country.

Second, the goods and services in both countries must be valued at the same prices. Relative prices in countries will differ, so goods and services should be weighted accordingly. For example, if more prices are lower in China than in the United States, China’s prices put a lower value on China’s production than would U.S. prices. If all the goods and services produced in China are valued using U.S. prices, than a more valid comparison can be made of real GDP in the two countries. This comparison using the same prices is called purchasing power parity (PPP) prices.

Big Mac Index (http://www.economist.com/content/big-mac-index): This is an impressive and interactive site for measuring PPP of the Big Mac. Students will immediately relate to this example and you can ask them what country they want to check on.

International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes. Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people .

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ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs $20 in New York might cost $1 in Calcutta. (You might get a better haircut in New York, but probably not one that is 20 times better!) Converting Indian GDP into U.S. dollars at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into U.S. dollars avoids this bias.

Limitations of Real GDP •

Some of the factors that influence the standard of living are not part of real GDP. Omitted from GDP are: • Household Production: As more services, such as childcare, are provided in the marketplace, the measured growth rate overstates development of all economic activity.

• Underground Economic Activity: If the underground economy is a reasonably stable proportion of all economic activity, though the level of GDP will be too low, the growth rate will be accurate.

• Health and Life Expectancy: Better health and long life are not directly included in real GDP. • Leisure Time: Increases in leisure time lower the economic growth rate, but we value our leisure time and we are better off with it.

• Environmental Quality: Pollution does not directly lower the economic growth rate.

• Political Freedom and Social Justice: Political freedom and social justice are not measured by real GDP.

The At Issue feature debates whether GNNP (Green net National Product) should replace GDP. Advocates say that a green measure is needed to take account of environmental damage that results from production; opponents say that other omissions from GDP are more important than environmental damage.

An Economics in Action describes the United Nation’s broader measure of wellbeing, the Human development Index.

YouTube Video: This is a wonderful video that should get anyone excited about data and its ability to help tell a story.

Hans Rosling's 200 Countries, 200 Years, 4 Minutes - The Joy of Stats - BBC Four http://youtu.be/jbkSRLYSojo

Measuring Real GDP and Economic Growth. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if you mow your own lawn, the value of your production doesn’t show up in GDP. But if you hire a student to mow your lawn (and if your student reports the income earned correctly to the IRS), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are the cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Survey.

You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted.

Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even .

MEASURING GDP AND ECONOMIC GROWTH

many, of them will see no problem with this. Then ask about the production of murder-for-hire. The response, we hope, will be significantly different. Does such a good have any value?

.

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Additional Problems

1.

Figure 4.1 shows the flows of expenditure and income for a small nation. During 2014, flow A was –$15 million, flow B was $40 million, flow C was $90 million, and flow D was $45 million. Calculate a. Aggregate expenditure. b. Aggregate income. c. GDP.

2.

The transactions in Jupiter last year are in the table to the right. a. Calculate Jupiter’s aggregate expenditure. b. Calculate Jupiter’s net exports. c. Calculate Jupiter’s government expenditure.

.

Item GDP Consumption expenditure Taxes Transfer payments Profits Investment Exports Saving Imports

Dollars 1.400,000 700,000 350,000 150,000 300,000 350,000 400,000 400,000 350,000

MEASURING GDP AND ECONOMIC GROWTH

3.

The table shows data from the United Kingdom in 2005. a. Calculate GDP in the United Kingdom. b. Explain the approach (expenditure or income) that you used to calculate GDP.

4.

Desert Kingdom produces Quantities 2016 only dates and camel rides.

Dates 1,000 pounds The base year is 2016, and the Camel rides 50 rides tables give the quantities produced and the prices in Prices 2016 and 2017. Calculate Dates $1 per pound Desert Kingdom’s Camel rides $100 per ride a. Nominal GDP and real GDP in 2016 and 2017. b. Real GDP in 2017 in terms of the base-year prices.

5.

Item Wages paid to labor Consumption expenditure Taxes Transfer payments Profits Investment Government expenditure Exports Saving Imports

47

Billions of pounds 685 791 394 267 273 209 267 322 38 366 2017 1,100 pounds 60 rides $2 per pound $120 per ride

Desert Kingdom (described in problem 3) decides to use the chain-weighted output index method of calculating real GDP. Using this method, calculate a. The growth rate of real GDP in 2017. b. Compare and comment on the differences in real GDP in terms of the base-year prices and real GDP calculated using the chain-weighted output index method.

Solutions to Additional Problems 1.

a.

b. c.

2.

a. b. c.

Aggregate expenditure is $160 million. Aggregate expenditure is the sum of consumption expenditure, investment, government expenditure, and net exports. In the figure, flow C is consumption expenditure, flow D is investment, flow B is government expenditure, and flow A is net exports. So aggregate expenditure equals $90 million plus $45 million plus $40 million minus $15 million, which is $160 million.

Aggregate income is $160 million. Aggregate income equals aggregate expenditure, which from part a is $160 million.

GDP is $160 million. GDP equals aggregate expenditure, which from part a is $160 million.

Jupiter’s aggregate expenditure is $1,400,000. Aggregate expenditure equals GDP and Jupiter’s GDP is $1,400,000.

Jupiter’s net exports equal $50,000. Net exports equal exports, $400,000, minus imports, $350,000.

Jupiter’s government expenditure was $300,000. Aggregate expenditure equals the sum of consumption expenditure, investment, government expenditure, and exports minus imports. That is, $1,400,000 equals $700,000 plus $350,000 plus government expenditure plus $400,000 minus $350,000. Solving this equation for government expenditure gives $300,000. .

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3.

a. b.

GDP in the United Kingdom was £1,223 billion.

The expenditure approach was used; that is, GDP was calculated by adding consumption expenditure, investment, government expenditure, and exports, and subtracting imports.

4.

a.

In 2016, nominal GDP is $6,000. In 2017, nominal GDP is $9,400.

Nominal GDP in 2016 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2016. Expenditure on dates is 1,000 pounds at $1 a pound, which is $1,000.

Expenditure on camel rides is 50 rides at $100 a ride, which is $5,000. Total expenditure is $6,000, so nominal GDP in 2016 is $6,000.

Nominal GDP in 2017 is equal to total expenditure on the goods and services produced by Desert Kingdom in 2017. Expenditure on dates is 1,100 pounds at $2 a pound, which is $2,200.

Expenditure on camel rides is 60 rides at $120 a ride, which is $7,200. Total expenditure is $9,400, so nominal GDP in 2017 is $9,400.

Real GDP in 2017 in terms of base-year prices is $7,100.

To calculate real GDP in 2017 in terms of base-year prices, we calculate market value of the 2017 quantities at the base-year prices of 2016. To value the 2017 output at 2016 prices, expenditure on dates is 1,100 pounds at $1 a pound (which is $1,100), and expenditure on camel rides is 60 rides at $100 a ride (which is $6,000). So real GDP in 2017 in terms of base-year prices is $7,100.

The growth rate of real GDP in 2017 is 17.9 percent.

The chain-weighted output index method uses the prices of 2016 and 2017 to calculate the growth rate in 2017.

The value of the 2016 quantities at 2016 prices is $6,000. The value of the 2017 quantities at 2016 prices is $7,100. We now compare these values. The increase in the value is $1,100. The percentage increase is ($1,100  $6,000)  100, which is 18.33 percent.

The value of the 2016 quantities at 2017 prices is $8,000. The value of the 2017 quantities at 2017 prices is $9,400. We now compare these values. The increase in the value is $1,400. The percentage increase is ($1,400  8,000)  100, which is 17.5 percent.

The chain-weighted output index calculates the growth rate as the average of these two percentage growth rates. That is, the growth rate in 2017 is 17.9 percent Real GDP in 2017 in terms of base-year prices is $7,100. Real GDP in 2017 using the chainweighted output index method is $7,074. Real GDP growth is fastest when real GDP is measured in terms of base-year prices.

b.

5.

a.

b.

Additional Discussion Questions 11. To estimate GDP you add the value of all the goods and services produced, both final and intermediate goods. Is this procedure correct? Why? Adding all the goods and services produced is incorrect because it will lead to significant double counting.

Intermediate goods and services will be double counted. For instance, if a CPU produced by Intel and then used in a Dell computer is counted both as a CPU from Intel and as part of the computer from Dell, the CPU has been double counted.

12. What is the relationship between aggregate income and aggregate production? Why does this relationship exist? Aggregate income equals aggregate production. The circular flow shows this result: The flow of production out of business firms equals the flow of expenditure into business firms. The flow of expenditure into business firms equals the flow of costs out of business firms. And the flow of costs out of business firms is the same as the flow of aggregate income to households.

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13. Does my purchase of a domestically produced Ford automobile that was manufactured in 20100 add to the current U.S. GDP? Why? How about my purchase of a domestically produced, newly produced Ford? Why? The purchase of the used Ford does not add to the current U.S. GDP though it did add to U.S. GDP in 20100 when the car was newly produced.

GDP measures production within a given time period and the used Ford was not produced within the current year. A new Ford automobile, however, is counted in current U.S. GDP because it was produced in the current year.

4.

Does my purchase of 100 shares of stock in Google add to the nation’s GDP? Why? Purchasing shares of stock does not add to the nation’s GDP. GDP measures production.

Shares of stock are not the production of a good or service and therefore are not included in GDP.

5.

If a homeowner cuts his or her lawn, is the value of this work included in real GDP? Suppose that the homeowner hires a neighborhood kid to cut the lawn. Is this activity included in real GDP? Comment on your answers. The homeowner’s work around his or her home is not included in GDP because home production is excluded. Hiring a neighborhood kid to cut the lawn is, in theory, included in GDP because it is a service that has been sold in a market. This difference in the treatment of these two activities shows a flaw in how GDP is computed. In both cases the precise same lawn is mowed. But in one case GDP is unaffected and in the other GDP increases. It is paradoxical that the effect on GDP of producing the same service depends on who produces the service.

6.

In 1900, the average work week was 65 hours; today it is approximately 35 hours. How did this change affect real GDP within the United States? How did it affect the standard of living within the United States? Comment on your answers. The decrease in the average work week decreases real GDP from what it would have been if the work week had remained at 65 hours because less time is spent at production of goods and services. Taken by itself, the decrease in real GDP means that the standard of living within the United States is lower. However the fall in the average work week also means a significant increase in people’s leisure time, which raises the standard of living. For many people it is likely the case that their standard of living is higher with the shorter work week—and hence lower level of real GDP—that it would be with the longer work week because they value their leisure more than the goods and services that would have been produced. But at the least, looking only at the change in real GDP as the sole measure of the standard of living is incorrect because that view ignores the gain in the standard of living from the increased leisure.

7.

In the United States, many children receive day-care from commercial providers. In Africa, this is unknown; children are almost all cared for by relatives. How would this difference affect comparisons of GDP per person? This difference means that U.S. GDP per person is biased higher than GDP per person in African countries. In both the United States and in Africa children are cared for so the same service is produced in both regions. But in the United States this service is included in GDP because it is purchased in a market; however, in Africa the service is not included in GDP because it is performed as household production.

.

C h a p t e r

5

MONITORING JOBS AND INFLATION**

The Big Picture Where we have been: Chapter 5 finishes introducing macroeconomic issues and describing how key macroeconomic variables are measured. The link developed in this chapter between employment and real GDP (from Chapter 4) is an important concept that helps serve as a foundation for the presentation of the aggregate production function in the next chapter.

Where we have been: This chapter increases students’ understanding of the types and sources of unemployment.

It also provides students with detail on the use of the CPI to measure inflation. Alternative price measures also are introduced. Perhaps more significantly, the explanation of the natural rate of unemployment and its relationship to potential GDP are important building blocks for the AS-AD model developed in Chapter 10 and the Phillips curve framework developed in Chapter 12. These topics also recur in Chapters 13 and 14 when fiscal and monetary policy is covered.

New in the Thirteenth Edition The content in Chapter 5 is substantially the same as in the 12th edition with a few nice improvements. The multiple graphs and data in this chapter have all been updated through 2017. An update to the Boskin commission bias analysis includes modifications made since 1996 to lower the size of the bias. The inflation section now includes the Sticky-Price estimate of inflation to complement the discussion about the core inflation rate. Economics In Action takes an interesting look at full employment issues. The current event topic, which can be found in the ‘Economics in the News’ section, discusses the relationship between labor force participation and the unemployment rate during the move to full employment.

*

* This is Chapter 22 in Economics. .

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Lecture Notes

Monitoring Jobs and Inflation • • • •

I.

The unemployment rate, the employment-to-population ratio, and the labor force participation rate are key labor market indicators.

The natural unemployment rate is the unemployment rate at full employment; it is comprised of frictional and structural unemployment.

The unemployment rate fluctuates over the business cycle.

The price level and the inflation rate are measured using the CPI as well as other price indexes.

Employment and Unemployment

Current Population Survey •

•

The U.S. Census Bureau measures the population, labor force, and amount of employment. The working-age population is the total number of people aged 16 years and over who are not in jail, a hospital, or some other form of institutional care. The labor force is the sum of the employed and the unemployed.

Unemployment occurs when someone who wants a job cannot find one. To be counted as unemployed, a person must be available for work and must be in one of three categories: • Without work but has made specific efforts to find a job within the previous four weeks • Waiting to be called back to a job from which he or she has been laid off • Waiting to start a new job within 30 days

Ask the students, “If I was to assign a homework assignment of estimating the unemployment rate in your city, how would you do it?” You will probably get an answer of “Google it,” but tell them that this is not an Internet mining project! Try to have some of your students suggest an in-person survey or a phone survey.

Now you can walk through some of the issues economists face with data collection (questions to ask, sample size, bias, etc.). Discuss how a grocery store may be a decent place to get a random sample of people from all demographics and how a phone survey might miss some poor, unemployed person without a phone or students who do not have a land-based phone.

Three Labor Market Indicators •

The unemployment rate is the percentage of the people in the labor force who are unemployed.

Number of peopleunemployed 100 and Labor force = Number of people employed + It equals Labor force Number of people unemployed. Between 1980 and 2017 the unemployment rate averaged 6.4 percent.

•

The employment-to-population ratio is the percentage of people of working age who have jobs.

Number of peopleemployed It equals 100. In recent years the employment-to-population ratio has Working- age population been about 62 percent. It has fallen since 2000 and in June 2017 was 60 percent.

•

The labor force participation rate is the percentage of working-age population who are members Labor force 100. The labor force participation rate has of the labor force. It equals Working - age population been declining since it reached about 67 percent in 2000 and in June 2017 was 62.7 percent.

Jobs and home production. It is interesting to ask students to think about appropriate measures of labor force participation over long periods of time or in very different economic arrangements. The technical definition involves spending time working for gain, or seeking work for gain. In the United States, this .

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51

usually equates to work outside the home. Ask students whether women who are unpaid family workers on farms are in or out of the labor force; and then ask whether they are if they don’t work outside the home, but cook, make and wash clothing, and otherwise maintain the household for a family.

•

• •

Marginally attached workers are people who are available and willing to work but currently are neither working nor looking for work. These workers often temporarily leave the labor force during a recession and decrease the labor force participation rate. Because they are no longer counted as unemployed, marginally attached workers lower the unemployment rate. A discouraged worker is a marginally attached worker who has stopped looking for work because of repeated failures to find a job.

Economic part-time workers are people who are working part-time but would like to find full time work. These workers are not unemployed by the U-3 standard but are considered “partunemployed.”

Marginally attached workers (and discouraged workers) as well as economic part-time workers who want a full-time job are not counted as unemployed in the official unemployment rate.

Real World Examples from the Class: Ask the class if anyone has an example of a ‘discouraged worker’ or someone who has taken a part-time job even though he or she wants a full-time job. It would be unusual if no one had a story to tell.

Alternative Measures of Unemployment

The BLS creates several alternative measures of unemployment to take account of the long-term unemployed (who lose the most from unemployment) and marginally attached workers: • U–1: includes only those unemployed for 15 weeks as unemployed.

• U–2: includes only job losers as unemployed.

• U–3: the official unemployment rate.

• U–4: adds discouraged workers to the official unemployment rate.

• U–5: adds all marginally attached workers to the official unemployment rate.

• U–6: adds part-time workers who want full-time jobs to the U-5 unemployment rate.

• Long-term unemployment (U–1) and unemployed job losers (U–2) are about 40 percent of the unemployed on average but 60 percent in a deep recession.

• Adding discouraged workers (U–4) makes very little difference to the unemployment rate, but adding all marginally attached workers (U–5) adds about one percentage point.

• A really big difference is made by adding the economic part-time workers (U–6). In June 2017, adding these workers to the U-5 unemployed increased the underemployed rate to 8.5 percent.

II. Unemployment and Full Employment Types of Unemployment •

•

•

Frictional unemployment is the unemployment that arises from normal labor turnover. These workers are searching for jobs. The unemployment related to this search process is a permanent phenomenon in a dynamic, growing economy. Frictional unemployment increases when more people enter the labor market or when unemployment compensation payments increase.

Structural unemployment is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs.

Sometimes there is a mismatch between skills demanded by firms and skills provided by workers, especially when there are great technological changes in an industry. Structural unemployment generally lasts longer than frictional unemployment. Minimum wages and efficiency wages create structural unemployment.

Cyclical unemployment is the fluctuating unemployment over the business cycle. Cyclical unemployment increases during a recession and decreases during an expansion. .

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Identifying frictional, structural, and cyclical unemployment. Ask your class if anyone they know has been laid off. Then discuss whether losing a job creates frictional, structural, or cyclical unemployment.

Look at your local examples. If you live in a steel-producing or car manufacturing area, for example, you can talk about local structural unemployment arising from the closing of factories due to international competition. For cyclical unemployment, ask students how they think the business cycle and cyclical unemployment is related to full-time enrollments at higher education institutions. Students often don’t think there is any relationship. But nationally during a recession, the growth rate of full-time enrollments increases. Ask students if they can explain this relationship. The answer is that during a recession and due to the increase in cyclical unemployment, the opportunity cost of school decreases. This is a great way to keep students thinking about marginal benefits and costs.

Work through each type of employment asking whether it is good or bad for society (call to their attention that it is usually bad for the individual, but may be good long term for society) • Frictional? Good because a healthy, dynamic, economy needs new entrants to the labor force , such ascollege graduates, and freedom for people to quit a job they don’t like.

• Structural? Good because a healthy, growing economy has technological change that makes some jobs obsolete.

• Cyclical? Bad because it is unfortunate to have unemployment strictly because of the cyclical nature of the economy. If it were possible to maintain the same level of economic growth with less fluctuation, we would have less cyclical unemployment with a higher level of welfare. Can and should the cycle be managed? This is a big question in Macroeconomics that we will continue to tackle!

“Natural” Unemployment •

•

Natural unemployment is the unemployment that arises from frictions and structural change when there is no cyclical unemployment—when all the unemployment is frictional and structural.

Natural unemployment as a percentage of the labor force is called the natural unemployment rate.

Full employment is defined as a situation in which the unemployment rate equals the natural unemployment rate.

What Determines the Natural Unemployment Rate?

• • •

•

The Age Distribution of the Population An economy with a young population has a large number of new job seekers every year and has a high level of frictional unemployment.

The Scale of Structural Change The scale of structural change is sometimes small but sometimes there is a technological upheaval. When the pace and volume of technological change and when the change driven by international competition increase, natural unemployment rises.

The Real Wage Rate The natural unemployment rate increases if minimum wage is raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a wage set above the equilibrium real wage to enable the firm to attract the most productive workers and motivate them to work hard and discourage them from quitting).

Unemployment Benefits Unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search.

There are two controversies that surround the natural unemployment rate. The first is the use of the term “natural,” which offends many who believe any unemployment is always a bad thing. From the perspective of an unemployed individual who has yet to find the job he or she wants, unemployment is bad. However, there is some level of unemployment that is good for society because it will help create more productive matches between firms and workers and allow for technological changes that lead to economic growth.

The second controversy is what level of unemployment corresponds to the natural rate. Because this .

MONITORING JOBS AND INFLATION

53

number is unobserved, it must be estimated. Some estimates imply the natural rate is stable and changes only slowly over time. Others imply that most of the fluctuations in unemployment are “natural”. These differences are important for macroeconomic policy because one of the typical goals of policy is to keep the unemployment rate from making wide swings around the natural rate.

Real GDP and Unemployment Over the Cycle •

When the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP. When the unemployment rate is greater than the natural unemployment rate, real GDP is less than potential GDP. And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP. The gap between real GDP and potential GDP is called the output gap.

Students often have an innate sense of an asymmetry in business cycle fluctuations around potential GDP. In particular, students often think that the economy is almost always below potential GDP. It is important for students to understand that it is possible for the economy to temporarily rise above potential GDP so that the unemployment rate is less than natural unemployment rate. One (small) example of this state of affairs occurred in Silicon Valley in the late 1990s when workers who became dissatisfied with a job could quit and be assured of a new job (often at higher pay!) within a few days. Indeed, firms paid for expensive radio advertisements “begging” for workers to apply for jobs.

III. The Price Level, Inflation, and Deflation The price level is the average level of prices. The average level of prices can be rising, falling, or stable.

Inflation occurs when the price level persistently rises; deflation occurs when the price level persistently falls. The inflation rate is the percentage change in the price level.

Why Inflation and Deflation are Problems •

• •

Unexpected inflation or deflation is a problem for society because they redistribute income and wealth. Unexpected inflation benefits workers and borrowers; unexpected deflation benefits employers and lenders. They motivate people to divert resources from producing goods and services to forecasting and protecting themselves from the inflation or deflation.

Unexpected deflation hurts businesses and households that are in debt (borrowers) who in turn cut their spending. A fall in total spending brings a recession and rising unemployment.

Hyperinflation is an inflation rate of 50 percent a month or higher

The Consumer Price Index • • •

The Consumer Price Index (CPI) is a measure of the average of the prices paid by urban consumer for a fixed “basket” of consumer goods and services. The CPI is calculated monthly by the Bureau of Labor Statistics.

The CPI is defined to equal 100 for a period called the reference base period. The current reference base period is 1982-1984, so the average CPI during that period was 100.

In June 2017, the CPI was 245.0. Thus, since 1982-84, prices increased by 145.0 percent.

Constructing the CPI •

The BLS conducts an infrequent survey of consumers to determine the average “basket” of goods and services purchased by urban household. Then each month the BLS records the prices of goods and services in the basket, keeping the representative items as similar as possible in consecutive months. The BLS uses the fixed basket quantities and the recorded prices to determine the cost of the basket each month. The CPI for the month equals 100 multiplied by the ratio of the cost in the current month to the cost in the base period.

.

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•

•

•

For example, suppose the initial survey Cost shows that the CPI basket is 2 books and Item Quantity Price (dollars) 20 coffees. The initial base period prices Books 2 $30 $60 and quantities are in the table to the Coffee 20 $2 $40 right. In this base period, say 2005, the Basket $100 cost of the CPI basket is $100.

Next suppose that the BLS survey taken one month in 2017 reveals that the price of Cost a book is $35 and the price of a coffee is $3.

Item Quantity Price (dollars) These 2017 prices and the initial base Books 2 $35 $70 period quantities are in the table to the Coffee 20 $3 $60 right. In this period the cost of the CPI Basket $130 basket is $130.

Using these data, the CPI equals ($130  $100)  100, or 130. So between the base period and the current period, the CPI has risen by 30 percent.

Measuring the Inflation Rate •

•

The inflation rate is the percentage change in the price level from one year to the next. In a formula,  CPI this year - CPI last year    100.

Inflation rate =  CPI last year   In June 2017, the CPI was 245. In June 2016, the CPI was 241. Using the formula, between 2017 and 2016, the inflation rate was 1.7%.

The Biased CPI •

The CPI has four biases that lead it to overstate the inflation rate. The biases are: • New Goods Bias: New goods are often more expensive than the goods they replace.

• Quality Change Bias: Sometimes price increases reflect quality improvements (safer cars, improved health care) and should not be counted as part of inflation.

• Commodity Substitution Bias: Consumers substitute away from goods and services with large relative price increases.

• Outlet Substitution Bias: When prices rise, people use discount stores more frequently and convenience stores less frequently.

The Magnitude and Consequences of the Bias •

The Boskin Commission in 1996 estimated the bias overstates the inflation rate by about 1.1 percentage points a year. The BLS has now corrected much of the bias with more frequent expenditure surveys to avoid substitution bias and by using statistical methods to lessen new goods and quality change bias. The bias in today’s CPI is almost certainly less than it was in 1996, but some remains.

In terms of government outlays linked to the CPI, such as Social Security, a bias of 1 percent amounts to close to a trillion dollars in additional expenditures over a decade.

Alternative Price Indexes •

Three alternative to the CPI are: • Chained CPI: The chained CPI is calculated similarly to chained GDP (discussed in the Mathematical Note to the previous chapter.) The chained CPI incorporates both new goods and the substitution of one good for another and so overcomes these sources of bias. But the difference between the chained CPI and regular CPI is small: on average, since 2000 the chained CPI is 0.7 percentage points lower per year. .

MONITORING JOBS AND INFLATION

•

•

55

Personal Consumption Expenditure Deflator (PCE deflator): The deflator from nominal and real Nominal consumption expenditure consumption expenditure. The PCE deflator equals 100. The Realconsumption expenditure basket of goods in the PCE deflator is broader than the basket in the CPI because it includes all consumption expenditure.

GDP Deflator: Similar to the PCE deflator, the GDP deflator is from nominal and real GDP. The Nominal GDP GDP deflator equals 100. The difference between the GDP deflator and regular RealGDP CPI is small: on average, since 2000 the GDP deflator is 0.4 percentage points lower per year.

Core CPI and Sticky-Price Inflation •

•

The inflation rate is often volatile. To strip out the volatile elements and focus on the underlying trend inflation, the core inflation rate is used. The core inflation rate is the CPI inflation rate excluding volatile elements. The core CPI inflation rate equals the percentage change in the CPI excluding food and fuel prices.

A new method of revealing the inflation trend is to calculate the sticky-price inflation rate, which is the rate at which infrequently adjusted prices are changing

Real Variables in Macroeconomics •

Real variables are measured in constant prices and can be considered to be measured in units of “goods and services.” In general nominal variables, such as the nominal wage rate and nominal Nominal variable GDP, are deflated to become real variables using the formula real variable = 100.

Price level The exception to this rule is the nominal interest rate. (In two chapters the students see that the real interest rate = nominal interest rate − inflation rate.)

The Economics in the News discusses “Job Growth at Full Employment.” It shows how the unemployment rate and labor force participation rate have interacted with each other as the economy reached full employment.

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Additional Problems 1.

Michigan: Unemployment Record Holder Michigan now holds a dubious record: It leads the U.S. in joblessness. The state’s unemployment rate was 8.5% in May while the U.S. unemployment rate was only 5.5%. The reason is clear: Detroit’s emphasis on big trucks and sport-utility vehicles has turned sour.

But even though the official unemployment numbers look awful, the reality is worse. The official number does not reflect those who have given up looking for a job.

Business Week, June 24, 2008 In 2010, at 13.6 percent of the state’s labor force, Michigan had the nation’s highest official unemployment rate. But in 2012, Michigan’s unemployment rate fell to 9 percent, a larger fall than that in the United States as a whole. Around 11,000 businesses in Michigan produce high-tech scientific instruments and components for defense equipment, energy plants, and medical equipment. a. Why was the reality of the unemployment problem in Michigan actually worse than the 8.5 percent unemployment rate statistic in 2008? b. Was this higher unemployment rate in Michigan frictional, structural, or cyclical? Explain. c. What factor led to the favorable 2012 employment results in Michigan compared to the U.S. average? Was this a frictional, structural or cyclical factor? Explain.

2.

The Great Inflation Bias In 1996 the Boskin Commission was established to determine the accuracy of the CPI. The commission concluded that the CPI overstated inflation by 1.1%. The commission described four biases in the way the CPI was determined.

Fortune, April 3, 2008 a. What are the main sources of bias that are generally believed to make the CPI overstate the inflation rate? By how much did Boskin estimate the CPI overstates the inflation rate? b. Do the substitutions among different kinds of meat make the CPI biased up or down? c. Why does it matter if the CPI overstates or understates the rate of inflation? d. What steps has the BLS taken since 1996 to lower the bias?

Solutions to Additional Problems 1.

a.

b.

The unemployment problem is worse than the 8.5 percent unemployment rate indicates for three reasons. First, the unemployment rate does not include marginally attached workers, such as discouraged workers. Second, the unemployment rate does not include part-time workers would want full-time jobs. Finally the unemployment rate counts only workers who are currently unemployed. If a company has announced that it will be laying off workers in the future, its workers are measured as employed even though they will shortly join the ranks of the unemployed.

The higher unemployment rate in Michigan is structural. Consumers are decreasing the number of U.S.-made large cars in favor of foreign-made smaller cars. And to the extent that consumers are buying U.S.-made cars, they are generally smaller cars, many of which are not manufactured in Michigan. So the skills possessed by Michigan workers are not the skills needed for jobs and the location of workers in Michigan is not the location of available jobs.

.

MONITORING JOBS AND INFLATION

2.

57

c.

The improved labor statistics for Michigan reflected a structural factor in that industries with goods in high demand were able to move to Michigan and use retrained skilled workers for their production.

a.

The Boskin Commission presented four reasons why the CPI overstates the inflation rate. The four sources of bias are the new goods bias (new goods often cost more than the good they replace); quality change bias (price hikes might reflect quality changes); commodity change bias (changes in relative price lead consumers to switch away from goods and services whose price has risen more rapidly than other goods and services); and, outlet substitution bias (people buy from lower-priced sources when prices rise). The Boskin Commission estimated that the CPI overstates the inflation rate by 1.1 percentage points.

Substitutions among different types of meat biases the CPI upward because the CPI ignores these substitutions. For instance, if the price of beef rises and the price of chicken does not change, then consumers respond by switching from beef to chicken. Consumers will eat (approximately) the same amount of protein as before but the substitution of chicken for beef means that their expenditure on protein will not change by the full amount of the price rise for beef. The CPI ignores this substitution and assumes that people buy the same amount of beef as before. Therefore the CPI erroneously reports that expenditure on protein has risen by the full amount of the price hike of beef. The article says that when consumers respond to a change in relative price by switching from one type of meat to another, the price of the new type can’t be compared to the price of the old type because consumers prefer the old type of meat to the new one. However the article’s statement can’t be literally true because consumers generally cannot think the second type of meat ranks at zero compared to the first type of meat. Hence allowing for no substitution biases the CPI upward because consumers will substitute from one meat to another when relative prices change.

Many decisions depend on the CPI and any errors in the CPI will lead to errors in these decisions.

For instance, some wage contracts are linked to the CPI. If the CPI overstates inflation, then the firms pay too much and some workers might lose their jobs if the firm decides to fire them.

Conversely if the CPI understates inflation, then workers are paid too little. Additionally the government links about a third of its expenditures, including Social Security payments, to the CPI, If the CPI overstates inflation, then government outlays rise more rapidly than justified whereas if the CPI understates inflation, then outlays do not rise enough to offset the true inflation rate.

The BLS has now corrected much of the bias with more frequent expenditure surveys to avoid substitution bias and by using statistical methods to lessen new goods and quality change bias. The bias in today’s CPI is almost certainly less than it was in 1996, but some remains.

b.

c.

d.

Additional Discussion Questions 1.

Should discouraged workers be counted as part of the unemployment rate? By definition, discouraged workers should not be counted as “officially” unemployed because they are not searching for employment. However, the real issue is whether the definition is appropriate. On the one hand, these people have given up looking for a job because they cannot find one. On the other hand, because these people have given up looking for a job they are quite unlikely to find one. Discouraged workers are different from other unemployed workers because discouraged workers are unlikely to find work since they have stopped search. All in all, it is probably better that discouraged workers not be counted directly with other unemployed workers because their low likelihood of finding work makes them fundamentally different than other unemployed workers.

2.

What harm is there in calling a part-time worker that wants full-time work unemployed? Unlike discouraged workers or marginally attached workers, these people .

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are employed. Interpretation of these statistics needs to be mindful that people may have a distorted view of what they want versus what they will do. The U-3 standard is based on their current situation and gives us actual knowledge of the current state of employment.

The U-6 measure, which includes these part-time workers, might have more uncertainty in its level. Nonetheless, it is helpful to see how all of the various alternative measures compare and useful data can be obtained from all of them.

3.

“Unemployment is bad for the unemployed individual and bad for the nation. Hence the government should force the unemployment rate to 0 percent.” Comment on this assertion, discussing both its feasibility and its desirability. The assertion is highly unfeasible. The laws necessary to drive the unemployment rate to 0 percent would be draconian. For instance, no college student would be allowed to graduate until he or she had a job lined up. Once employed, workers would be forbidden to change jobs unless they had another job already arranged. Furthermore consumers would be forbidden to change their consumption baskets because if enough people changed, a firm might go bankrupt…allowing its workers to become unemployed. The assertion is similarly undesirable. Some unemployment is productive for the individual because it allows the worker to leave one job from which he or she is dissatisfied, to look for another job that will be a better match for the worker’s talents and skills.

4.

How can the unemployment rate be less than the natural rate? The unemployment rate can be less than the natural unemployment rate when the cyclical unemployment rate is negative. This outcome can occur when the economy is in a strong expansion. When the economy is growing rapidly, unemployed workers find jobs quickly. In many instances the match between worker and job will be poor: The firm is eager to find a worker and the worker accepts the offered job to end his or her spell of unemployment. But then as time passes the match is discovered to be poor—the worker does not perform well and/or dislikes the job. This situation is bad for the business and bad for the worker.

5.

How do you think the business cycle affects the duration of unemployment? On the average, unemployment has a longer duration in recessions and a shorter duration in expansions.

6.

Why is a change in the age structure of the population, increasing the proportions of young or old workers in the labor force, likely to change the natural unemployment rate? When the proportion of young workers increases, the natural unemployment rate rises because young workers change jobs more frequently than experienced workers. As these young workers change their jobs, frictional unemployment and, therefore, natural unemployment rise. Older workers are less prone to change jobs because they have had more time to find a good job match. The frictional unemployment rate is lower and so, too, is the natural unemployment rate when the proportion of old workers in the labor force is higher.

7.

What is the natural unemployment rate? What is the controversy concerning its measurement? The natural unemployment rate is the unemployment rate when the economy is at full employment. The natural rate is comprised of frictional and structural unemployment. One controversy arises because it is difficult to measure frictional and structural unemployment. Another controversy arises because the issue of whether discouraged workers and marginally attached workers should be included in the natural rate is unclear. While the number of these workers can be measured with reasonable accuracy, whether they should be included in the natural rate is controversial.

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6

ECONOMIC GROWTH**

The Big Picture Where we have been: Chapter 6 focuses on economic growth. It uses the definitions and concepts of aggregate income and real GDP presented in Chapter 4 as well as tying economic growth in the macroeconomy to the PPF of Chapter 2.

Where we are going: Chapter 6 is the first of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on finance and investment, money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 6 provides the long run fundamental variables and results that need to be remembered as various other models are developed in future chapters. Chapter 6 (and Chapter 7) is particularly useful in Chapter 13 when the supplyside effects of fiscal policy are covered.

New in the Thirteenth Edition The chapter’s content and coverage are about the same as in the 12th edition. All time series data are updated through 2016. The text and figure regarding real GDP Growth in the World Economy now shows the time frame 1980 to 2016 and includes Mexico, Russia and Nigeria rather than the more general regions they occupy. Economics in Action has a new analysis of the growth rate slowdown in the United States by looking at work hours and labor productivity.

Recent American and Canadian economic growth rates are compared in the Economic in the News revealing differences in how the two neighboring countries grew. Three new questions regarding economic growth in countries now in ‘Additional Problems and Applications.

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* This is Chapter 23 in Economics. .

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Lecture Notes

Economic Growth You can start your discussion of this chapter by listing on the board or on an overhead various countries ranked from highest per capita real GDP to lowest. It is a real eye opener for students to consider income per person because it really shows how fortunate we are in the United States. Tell your students that in the 1960s countries like Hong Kong, Singapore and Japan used to rank around where China ranks today.

Explain that this extraordinary growth is part of what motivated economists over the last 20-30 years to try to deduce how this type of growth can occur. Is it possible the United States could do something differently to grow at those growth rates? Is the neoclassical model correct in its prediction that there will be a global equilibrium in which all nations have the same real GDP per person? Then leave your students with the fact that China is 200 times the population of Hong Kong and 4 times the population of the United States. This brings the obvious question: Should we be concerned?

• • •

I.

Economic growth leads to large changes in standards of living from one generation to the next.

Economic growth rates vary across countries and across time.

There are different economic theories to explain these variations in growth rates.

The Basics of Economic Growth •

The economic growth rate is the annual percentage change of real GDP. This growth rate is equal to: RealGDP in current year− Re al GDP in past year Real GDP growth rate =  100 Re al GDP in past year

•

The standard of living depends on real GDP per person, which is real GDP divided by the population. The growth rate of real GDP per person can be calculated using the formula above, though substituting real GDP per person.

• The growth rate of real GDP per person also approximately equals the growth rate of real GDP minus the population growth rate.

Real GDP can increase for two distinct reasons: The economy might be returning to full employment in an expansion phase of the business cycle or potential GDP might be increasing.

•

The movement from point A to point B reflects an expansion phase of the business cycle. It occurs with no change in production possibilities. Such an expansion is not economic growth.

•

The increase in aggregate production reflected by the movement from point B on PPF0 to point C on PPF1 is economic growth—it reflects an expansion of production possibilities shown by an outward shift of the PPF.

The Rule of 70 is useful for determining how long it will take for a variable to double. The Rule of 70 states that the number of years it takes for the level of any variable to double is approximately 70 divided by the annual percentage growth rate of the variable.

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Run through an example of the rule of 70 that does not relate to economic growth. Examples: If tuition rates rise at 6 percent per year, how long will it take it to double? 70/6 = 11.67 years. If you invest $10,000 at 12 percent interest, how long will it take to double your money? 70/12 = 5.83 years.

Compound Interest: You can reinforce the importance of economic growth by relating the fact that if real GDP per person had grown just 0.25 percentage points faster between 1960 and the present, every household today, on average, would have almost $12,000 more income (every person would have $4,500 more). If real GDP per person had grown 1 percentage point faster between 1960 and the present, every household today, on average, would have $50,000 more income (every person would have $21,200 more).To make concrete just how much better off we would have been, get the students to list what they would buy with an extra $21,200 a year.

II. Long-Term Growth Trends Long-Term Growth in the U.S. Economy The growth of real GDP per person in the United States has fluctuated but has averaged 2 percent per year over the last century. The growth rate was 1.8 percent prior to the Great Depression and 2.1 percent after World War II.

Real GDP Growth in the World Economy Economic growth varies across countries. Among richest countries, there seems to be some convergence of real GDP per person but most other countries show less evidence of convergence. The “Asian Miracle” is the fast rate of convergence for Hong Kong, Singapore, Taiwan, Korea, and China.

Is there convergence or divergence in standards of living? What is the role of economic growth for economic inequality? These are highly controversial questions. Most anti-globalization activists treat it as incontrovertible that economic growth creates higher inequality. But this view is likely incorrect. First, there has been a general convergence of standards of living over the past 50 years. This fact is in part the result of economic growth in China with a population that accounts for close to one-fifth of humanity.

Second, while some nations have fallen behind, those less developed countries that have grown fastest are those that have been most involved in “globalization” by becoming more integrated into global markets for goods and capital. The policy suggestions of the anti-globalization movement, such as reducing foreign trade and international capital mobility or even abandoning capitalism, property rights, and markets are the policies that are currently most practiced in countries that have grown the slowest. This result might not be a coincidence.

III. How Potential GDP Grows Potential GDP is the amount of real GDP that is produced when the quantity of labor employed is the fullemployment amount. To determine potential GDP we use the aggregate production function and the aggregate labor market.

The Aggregate Production Function •

•

The aggregate production function is the relationship between real GDP and the quantity of labor employed when all other influences on production remain the same.

The figure shows an aggregate production function.

The additional real GDP produced by an additional hour of labor when all other .

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influences on production remain the same is subject to the law of diminishing returns, which states that as the quantity of labor increases, other things remaining the same, the additional output produced by the labor decreases. The production function in the figure shows the law of diminishing returns because its shape demonstrates that as additional labor is employed, the additional GDP produced diminishes.

The Labor Market The Demand for Labor • The demand for labor is the relationship between the quantity of labor demanded and the real wage rate.

• The real wage rate equals the money wage rate divided by the price level. The real wage rate is the quantity of goods and services that an hour of labor earns and the money wage rate is the number of dollars that an hour of labor earns.

• Because of diminishing returns, firms hire more labor only if the real wage falls to reflect the fall in the additional output the labor produces. There is a negative relationship between the real wage rate and the quantity of labor demanded so, as illustrated in the figure, the demand for labor curve is downward sloping.

The Supply of Labor • The supply of labor is the relationship between the quantity of labor supplied and the real wage rate.

• An increase in the real wage rate influences people to work more hours and also increases labor force participation. These factors mean there is a positive relationship between the real wage rate and the quantity of labor supplied so, as illustrated in the figure, the supply of labor curve is upward sloping.

Labor Market Equilibrium and Potential GDP • In the labor market, the real wage rate adjusts to equate the quantity of labor supplied to the quantity of labor demanded.

In equilibrium, the labor market is at full employment. In the figure, the equilibrium quantity of employment is 200 billions of hours per year.

• Potential GDP is the level of production produced by the full employment quantity of labor. In combination with the production function shown in the previous figure, the labor market equilibrium in the figure of 200 billion hours per year means that potential GDP is $18 trillion.

What Makes Potential GDP Grow?

Potential GDP grows when the supply of labor grows and when labor productivity grows.

Growth of the Supply of Labor • The supply of labor increases if average hours per worker increases, if the employment-topopulation ratio increases, or if the working-age population increases. Of these factors, in the United States over the past years the first two have offset each other.

• Only increases in the working-age population can cause persisting economic growth. Persisting increases in the working-age population result from population growth. .

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An increase in population increases the supply of labor, which shifts the labor supply curve rightward. The real wage rate falls and the quantity of employment increases. The increase in employment leads to a movement along the production function to a higher level of potential GDP.

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An Increase in Labor Productivity • An increase in labor productivity increases the demand for labor and shifts the production function upward.

• As the top figure illustrates, the increase in the demand for labor from LD0 to LD1 raises the real wage rate, from $20 to $30 per hour in the figure, and increases the level of employment, from 200 billion hours per year to 300 billion hours per year.

• The bottom figure shows that the production function has shifted upward, from PF0 to PF1.

Combined with the increase in employment to 300 billion hours per year, the increase in labor productivity increases potential GDP from $18 trillion to $23 trillion.

• An increase in labor productivity leads to an increase in real GDP per person and increases the standard of living.

IV. Why Labor Productivity Grows Preconditions for Labor Productivity Growth •

•

The institutions of markets, property rights, and monetary exchange create incentives for people to engage in activities that create economic growth and are preconditions for growth in labor productivity. Market prices send signals to buyers and sellers that create incentives to increase or decrease the quantities demanded and supplied.

Property rights create incentives save and invest in new capital and develop new technologies.

Monetary exchange creates incentives for people to specialize and trade.

Persistent growth requires that people face incentives to create: • Physical Capital Growth: Saving and investing in new capital expands production possibilities.

• Human Capital Growth: Investing in human capital speeds growth because human capital is a fundamental source of increased productivity and technological advance.

• Technological Advances: Technological change, the discovery and the application of new technologies and new goods, has made the largest contribution to economic growth.

The Causes of Economic Growth: A First Look; The limits of economics. The major obstacles to growth are political, and economists don’t know much about how to remove those political obstacles. You can give your students a glimpse of these obstacles in their worst form by reminding them of news video clips they’ve almost certainly seen of Kabul, Mogadishu, and other troubled cities in which the rule of law has completely broken down. Economists know a lot about how to make an economy grow if the preconditions are in place, but virtually nothing about how to bring those preconditions about.

The preconditions. The three preconditions for growth—markets, property rights, and monetary exchange—are all essential to create acceptable levels of risk and low enough transaction costs to justify .

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investment, specialization, and exchange. If you want to spend time on it, you can generate an interesting discussion on whether what matters is the particular system of property rights, or just that they be clear, certain, and enforceable with reasonable cost—the concept of the rule of law. Most students have never realized that property rights are highly varied, and many fast growing economies have nothing like U.S. absolute property rights in land, for example.

Interactions of sources of growth. Most students can see immediately how investment in physical and human capital in the form of education and training contribute to growth. Some have more difficulty getting a clear view of the role of learning by doing and technical change, particularly the small continuous refinement and improvement to existing technology rather than the spectacular breakthroughs. Much growth probably comes from the interaction of the last two, and this source of growth can be illustrated with a discussion of why firms offer incentives to workers to suggest improvements to working methods and procedures.

V. Is Economic Growth Sustainable? Theories, Evidence, and Policies.

Classical Growth Theory Classical growth theory is the view that real GDP growth is temporary and that when real GDP per person rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.

•

A problem with the classical theory is that population growth is independent of economic growth rate.

Classical growth theory is based on the work of Thomas Malthus, an economist from the early nineteenth century. Very few modern-day economists would refer to themselves as Malthusians. But, as the textbook says, there are many other people today who are Malthusians. The persistence of this viewpoint represents what one can only refer to as the triumph of despair over experience. At some point in history, Malthusian theory might have been applicable. But certainly since the industrial revolution, parents have chosen to concentrate on the quality of children not the quantity. And this shift in emphasis only gets stronger as economic growth advances. Thus, the assumption that the population growth rate is primarily determined by economic growth with a positive relationship has no basis in reality. Indeed, some of the richest countries in the world, such as Sweden and Japan, have some of the lowest birth rates.

Neoclassical Growth Theory Neoclassical growth theory is the proposition that the real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow.

• • • • •

A technological advance increases productivity. Real GDP per person increases.

The technological advances increase expected profit. Investment and saving increase so that capital increases. The increase in capital raises real GDP per person.

As more capital is accumulated, eventually projects with lower rates of return must be undertaken so that the incentive to invest and saving decrease. Eventually capital stops increasing so that economic growth stops.

The improvement in technology permanently increases real GDP per person.

A problem with the neoclassical theory is that it predicts that real GDP per person in different nations will converge to the same level. But in reality, convergence does not seem to be taking place for all nations.

An Economics in Action detail discusses the key role played by intellectual property rights. The section focuses on the start of the Industrial Revolution and looks at how England’s patent system helped sustain the revolution.

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New Growth Theory New growth theory holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely.

• • • • • •

•

The theory emphasizes that discoveries result from choices, discoveries bring profit, and competition then destroys the profit. It also stresses that knowledge can be used by everyone at no cost and knowledge is not subject to diminishing returns.

The ability to innovate means new technologies are developed and capital accumulated as in the neoclassical model. The production function shifts upward. Real GDP per person increases.

The pursuit of profit means that more technological advances occur and the production function continues to shift upward. Nothing stops the upward shifts of the production function because the lure of profit is always present.

The ability to innovate determines how capital accumulation feeds into technological change and the resulting growth path for the economy. Productivity and real GDP constantly grow.

The Classical Model. Explain that more capital and more productive capital that uses new technologies increases productivity, shifts the production function upward, and shifts the demand for labor curve rightward. Real GDP increases and on the average, the real wage rate rises.

You might then spend a few minutes agreeing that capital accumulation and technological change decrease the demand for the labor that the new capital replaces. But it increases the demand for other types of labor—complementary labor. People must acquire more skill—some people learn to work with the new capital, some learn how to maintain it in good condition, some learn how to build it, some learn how to market and sell it, some learn to design new ways of using it, some work on thinking up new goods and services to produce with it, and so on. All of these people are more productive that they were before.

New technologies that create new products have even more obvious effects on productivity. The development of the CD in the early 1980s is a good example. Suddenly thousands of people became very productive converting the heritage of recorded music into digital format, cleaning up the sound, and making and selling millions of CDs. The same type of thing is now happening with the conversion of media to digital formats for all of our digital devices and uploading to cloud services such as YouTube.

Historical development of theories and an aside. The three growth theories studied in this chapter— classical, neoclassical, and new—are presented in historical order. Point out this fact to the students to emphasize and illustrate how economic theory builds on itself. (An aside for you, not your students: Note that the chapter skips the Keynesian era Harrod-Domar model. The main reason for this omission is that these models were quickly shown to be in error and never formed the basis of a seriously proposed growth theory. Based on fixed coefficients and fixed saving rates, the Harrod-Domar model produces either secular stagnation or secular inflation. Neither phenomenon occurs in real economies. Solow’s neoclassical model was developed, historically, to show the error of the Harrod-Domar model, but the neoclassical model also builds naturally on its classical predecessor, and that is the sequence in the textbook.)

Classical theory. Start with the classical theory. The classical theory of growth takes technological change as exogenous, essentially ignores the role of capital (as a result of the era in which it was developed), and assumes that population growth increases when income increases (also as a result of the era in which it was developed). As a result, the conclusions from the classical theory are “dismal” indeed! Some students find it interesting to know that Thomas Malthus, most closely associated with the population part of this theory, was a clergyman, but was also the first person in the Anglophone world to hold the title of Professor of Political Economy (at the East India College). Economists came to realize that capital accumulation and technological change were important parts of the growth process. They also came to

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understand that population growth does not necessarily increase with income. Hence the stage was set for the neoclassical theory.

Neoclassical theory. Neoclassical theory follows the classical theory by taking technological growth as exogenous. It differs insofar as it assumes that population growth also is exogenous. The major difference is that neoclassical theory stresses the role played by technological change and how it influences saving and capital accumulation. So of the two differences between neoclassical and classical growth theory, the first—the different assumptions about how population growth is determined—reflects an advance in empirical knowledge of the relationship between population growth and income. The second difference— the importance given to technological change, saving, and capital—shows how the neoclassical theory built on the simpler classical model.

New growth theory. Neoclassical theory also is incomplete because the primary engine of economic growth, technology, is exogenous. New growth theory attempts to overcome this weakness. It still uses many of the insights of the neoclassical theory by emphasizing the role of capital accumulation and assuming that population growth is exogenous. But the new growth theory builds on neoclassical theory by examining more closely the role of technology and the factors that influence technological advances.

Giving the students this type of broad overview before presenting the details of the different models is important because it, along with the text’s outstanding overview, allows the students to see the forest as well as the trees. This knowledge not only helps them understand the particular models, but it also helps them gain an appreciation of how economics progresses. (Of course, progress is hardly as steady as the students might believe; for instance, Pigou and Ramsey presented important papers about growth in the early part of the twentieth century, but, nonetheless, progress has been made.)

The Empirical Evidence on the Causes of Economic Growth •

Economists have studied the growth rate data for more than 100 countries for the period since 1960 and explored the correlations between the growth rate and more than 60 possible influences on it. The conclusion of this data crunching is that most of these possible influences have variable and unpredictable effects, but a few of them have strong and clear effects. Amongst the strongest are: • International Trade: Nations that are open to trade grow more rapidly • Investment: Nations that have more investment in human capital and physical capital grow more rapidly.

• Market Distortions: Nations that have more exchange rate controls, price controls, and black markets grow more slowly.

• Economic System: Capitalist nations grow more rapidly.

• Politics: Nations that support the rule of law and protect civil liberties grow more rapidly.

Nations that have revolutions, military coups, or fight wars grow more slowly.

• Region: Nations located far from the equator grow more rapidly; nations in Sub-Sahara Africa grow more slowly.

Policies for Achieving Faster Growth •

Growth theory and the empirical evidence suggest some policies that might stimulate growth: • Stimulate saving, to increase capital accumulation • Stimulate research and development, to increase technology • Improve the quality of education, to increase human capital.

• Provide international aid to developing nations. However studies show that aid tends to get diverted to consumption. If the objective is to increase growth, then the aid must be carefully directed.

• Encourage international trade, to increase international specialization

Economic Freedom of the World Index: https://www.fraserinstitute.org/economic-freedom/economicfreedom-basics .

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I like to bring in Economic Freedom to the discussion of this chapter. The website link above brings you to many classroom items you can use like a short video, interactive world map, and power point presentations that refer to the data collected on five categories that make up a single index number that allows the researchers to rank countries according to the amount of economic freedom. Students relate very easily to the correlations drawn between economic freedom and important variables like life satisfaction, income, life expectancy, political rights, civil rights, etc.

The chapter concludes with an Economics in the News analysis of economic growth in Canada compared to its neighbor, the United States, Details on the use of technology and its impact on productivity and growth show a nice short term and long term analysis of recent data for both countries.

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Additional Problems 1.

If in 2008 China’s real GDP is growing at 9 percent a year, its population is growing at 1 percent a year, and these growth rates continue, in what year will China’s real GDP per person be twice what it is in 2008?

2.

Underinvesting in the Future For the past half century, South Korea, Hong Kong, Taiwan and Singapore have averaged the highest consistent economic growth rates in the world. But in one vital respect these countries may have the worst record of investment in the future since homo sapiens evolved: They have the lowest fertility rates in the world. For economic growth, raising children is at least as raising new buildings.

International Herald Tribune, July 7, 2008 a. Explain why the rapid growth rates of these Asian economies might be masking a misallocation of resources that will result in lower income per person in the future. b. Explain the difficulties in balancing goals for immediate economic growth and future economic growth.

Solutions to Additional Problems 1.

2.

China’s real GDP is growing at 9 percent a year and its population is growing at 1 percent a year, so China’s real GDP per person is growing at 8 percent a year. The rule of 70 tells us that China’s real GDP per person will double in 70/8 = 8¾ years. So at this rate China’s real GDP per person will be twice what it is in 2008 in 2017. a.

b.

The new growth theory concludes that population growth increases economic growth because population growth means more people to develop new knowledge and new technologies. The Asian economies are currently growing rapidly but their population growth is extremely slow. The new growth theory predicts that the slow population growth means that in the future their economic growth rates will slow.

People have a limited amount of time, which they can spend at work, perhaps developing new knowledge or new technology, or at home, raising children. If they spend their time at work, immediate economic growth will be higher than if they spend the time at home. But if they spend their time at home raising children, the future economic growth will be higher as the population growth is higher.

Additional Discussion Questions 11. What has been the average annual growth in real GDP per person in the United States over the last 100 years? Over the past 50 years, during which periods has annual growth been more rapid than the average? When has it been slower? The average annual growth rate in real GDP per person in the United States has been 2 percent over the past 100 years. Growth was most rapid in the 1960s. It was also rapid in the 1990s. Growth slowed in the 1970s. This slowdown is the “productivity growth slowdown.”

12. What is an aggregate production function? A change in what factor or factors cause a movement along the aggregate production function? A change in what factor or factors shifts the aggregate production function? The aggregate production function shows the relationship between real GDP and the quantity of labor employed when all other influences .

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on production remain the same. Changes in employment create movements along the aggregate production function. Changes in other factors of production, such as capital, as well as changes in technology, shift the aggregate production function.

13. Define labor productivity. Why is labor productivity important? Labor productivity is equal to real GDP divided by aggregate labor hours, so it tells the quantity of real GDP produced by an hour of labor. Labor productivity is important because it is directly related to the standard of living. The standard of living is real GDP per person so labor productivity is essentially the “standard of living per worker.” Therefore an increase in labor productivity means there is an increase in the standard of living.

14. Explain why reducing uncertainty with respect to property rights is regarded as likely to stimulate economic growth. Necessary preconditions for economic growth are physical capital growth, human capital growth, and technological advances. However people are willing to invest in physical capital and human capital only if they believe they will be able to reap the rewards from their investment. If property rights are unsecure, so that investors are unsure if they will gain from the investment, then people are much less likely to invest in either physical capital or human capital. Uncertainty about property rights therefore will dramatically slow economic growth because it will slow growth in physical and human capital. The story about technology is similar: People are willing to invest in new technology only if they believe they personally will reap the rewards. Once again, reducing uncertainty about property rights will increase people’s incentives to develop new technology, which will lead to more rapid economic growth.

15. What role do technological advances play in the classical theory of growth? The neoclassical theory? The new theory? In all the growth models a technological advance raises economic growth and real GDP per person. But whether the increase is temporary or permanent differ among the models. In the classical growth model a technological advance temporarily raises economic growth and real GDP per person. After the advance economic growth ceases. And the ensuing increase in population drives real GDP per person back to the subsistence level. In the neoclassical growth model a technological advance temporarily raises economic growth and permanently raises real GDP per person. After the advance economic growth ceases. But the increase in the capital stock brought about by the advance allows real GDP per person to remain permanently higher. In the new growth theory a technological advance permanently increases economic growth and real GDP per person. In the new growth theory a technological advance creates new profit opportunities so that pursuit of profit leads to still more technological advances and investment in capital. As a result economic growth persists. And with the persistence of economic growth, the increase in real GDP per person is permanent and increasing over time.

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7

FINANCE, SAVING, AND INVESTMENT**

The Big Picture Where we have been: This chapter builds on the definition of real GDP from Chapter 4 to explain how investment is financed. It also uses the demand and supply model explained in Chapter 3. The chapter explains how equilibrium in the loanable funds market determines the real interest rate and quantity of investment. It also discusses how government actions affect this market.

Where we are going: Chapter 7 is the second of four chapters that examine the economy in the long run when the economy is at full employment. The following chapters focus on money and the price level, and the exchange rate and balance of payments. After these chapters the next section examines macroeconomic fluctuations by developing the AS-AD model. The material presented in Chapter 7 is used in many of the following chapters. For instance the result that the real interest rate is determined in the loanable funds market is important in the next chapter to help determine the long-run effects from changes in the quantity of money.

The loanable funds model also is used in Chapter 13 when examining the supply-side effects of fiscal policy.

New in the Thirteenth Edition A substantial change in this chapter is the new section called Financial Decisions and Risk. It contains some of the previous content on insolvency, illiquidity and real interest but adds nice coverage of time value of money. The first Economics In Action box is moved to a later section on financial institutions highlighting flows of funds in the United States. Data throughout the chapter are updated through 2017. The Economics In The News has 2017 article discussing interest rates on corporate bonds and teases out the potential distortions in some markets that could be signs of future correction needed. For example, Tesla motors was able to raise substantial funds despite being unprofitable.

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* This is Chapter 24 in Economics. .

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Lecture Notes

Finance, Saving, and Investment • •

I.

The supply and demand for loanable funds determine the real interest rate and the quantity of loanable fund and investment.

Government budget deficits might also affect the real interest rate and quantity of investment.

Financial Institutions and Financial Markets

Finance and Money; Capital and Financial Capital • •

Finance and money differ: • Finance refers to providing the funds used for investment.

• Money refers to what is used to pay for goods and services.

Capital and financial capital differ: • Capital consists of physical capital, the tools, instruments, machines, buildings, and other items that have been produced in the past and that are used to today to produce goods and services.

• Financial capital is the funds that firms use to buy physical capital.

Definitions and the meaning of investment in economics. The student has met the key definitions of investment in this chapter, but to be absolutely sure that they are remembered it is worth emphasizing that in economics, “capital” and “investment” without any qualification mean physical capital and purchase of newly produced physical capital goods. Everyday usage of investment as the purchase of stocks or bonds can lead to confusion. So it is worth getting these matters clear right from the start.

Capital and Investment; Wealth and Saving •

The quantity of capital changes because of investment and depreciation. Gross investment is the total amount spent on new capital; net investment is the change in the capital stock. Net investment equals gross investment minus depreciation.

A concrete understanding of stock and flow variables is an important building block to understanding economic principles. You can use “buckets” to convey the relationship between stock and flow variables.

Buckets are easy to draw along with a simple faucet and hole in the bucket. You can use this illustration to show how the stock changes over time due to the inflow and outflow of material into the bucket. You can extend the use of buckets to any stock/flow concept, such as wealth and saving. For use with the capital stock, draw a bucket with a “K” on it. At a point in time there is fixed amount of capital in the bucket. Over some time period, investment flows in the top and depreciation flows out. The net effect of these two flows leaves the bucket higher or lower at the end of that time period.

•

Wealth is the value of all the things people own; saving is the amount of income not paid in taxes or spent on consumption. Saving adds to wealth. Wealth also changes when the market value of wealth changes.

Financial Capital Markets Financial markets transform saving and wealth into investment and capital.

• Loan markets: Both businesses and households obtain loans from banks. Financing for inventories, purchasing houses, and so forth can be obtained in this market.

• Bond markets: Businesses and governments can raise funds by issuing bonds. A bond is a promise to make specified payments on specified dates. One type of bond is a mortgage-backed security, which entitles its owner to the income from a package of mortgages. The failure of many mortgagebacked securities to make their specified payments was a factor leading to the financial crisis in 2007 and 2008.

• Stock markets: Businesses can raise funds by issuing stock. A stock is a certificate of ownership and a claim to the firm’s profit. .

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Financial Institutions •

A financial institution is a firm that operates on both sides of the markets for financial capital by being a borrower in one market and a lender in another market. Financial institutions include, commercial banks, government-sponsored mortgage lenders (Fannie Mae and Freddie Mac), pension funds, and insurance companies.

Moral Hazard and the 2008 Financial Crisis: Essentially securities, such as mortgage-backed securities, lost value and many financial institutions became insolvent. These institutions, such as Fannie Mae, Freddie Mac, Bear Sterns, AIG, and others were considered “too large” to fail. While you cannot fully explain the reasons why failure of a large financial institution might have external costs, your students can readily appreciate the point that if these institutions failed many borrowers would find it significantly more costly to arrange loans. The government acted in most all of these cases by arranging a bailout in form or another. Some companies were given government loans (AIG received an $85 billion loan from the Fed); others were taken into government oversight (Fannie Mae and Freddie Mac); others were merged into healthier companies, albeit with government assistance (Bear Sterns); a few were allowed to fail (Lehman Brothers).Even beyond these events, most financial institutions were given government assistance in the form of government loans and/or government purchase of stock.

Funds that Finance Investment • •

The funds that finance investment are from household saving, the government budget surplus, and international borrowing.

Households’ income is consumed, saved, or paid in net taxes (taxes paid to the government minus transfer payments received from the government): Y = C + S + T. GDP equals income and also equals aggregate expenditure, so Y = C + I + G + (X − M). Combining shows that C + S + T = C + I + G + (X − M), which can be rearranged to show how investment is financed:

I = S + (T − G) + (X − M).

This formula shows that investment is financed using private saving, the government budget surplus, (T − G), and borrowing from the rest of the world, (X − M).

• The sum of private saving, S, plus government saving, (T − G), is national saving.

• If we export less than we import, (X − M) is negative and we borrow (M − X) from the rest of the world.

• If we export more than we import, (X − M) is positive and we loan (X − M) to the rest of the world.

II. Financial Decisions and Risks Financial markets allow us to decide when to use scarce resources and how to manage the risks from these decisions. Because time is involved in these decisions, the value of money at different points in time must be compared.

The Time Value of Money •

To compare current and future dollars, we convert future dollars, called “future value,” to current dollars, called “present value.”

• The present value of a future dollar is the amount that will grow to be as large as that future value when the interest that it will earn is considered. In terms of a formula,

where r is the interest rate and n is the number of years the future value is from the present time.

Net Present Value .

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The decision of “invest” versus “don’t invest” or “buy an asset” versus “don’t buy the asset” comes down to whether or not the present value of the future income stream is greater than or less than the initial cost to acquire the asset.

• The net present value formula is:

NPV = (Present Value of Income Stream) – Initial Cost

•

If NPV > 0, make the investment or buy the asset. buy it. If NPV < 0, don’t make the investment or buy the asset

Financial Risk: Insolvency and Illiquidity • •

A financial institution’s net worth is the total market value of what it has lent minus the market value of what it has borrowed. If the net worth is positive, the institution is solvent and can remain in business. If the net worth is negative, the institution is insolvent and might go out of business.

A firm is illiquid if it can not meet a sudden demand to repay what it has borrowed because it does not have enough available cash. A firm can be illiquid but solvent.

Market Risk: Interest Rates and Asset Prices • •

Stocks, bonds, short-term securities, and loans are financial assets.

The interest rate on a financial asset is equal to the interest paid on the asset expressed as a percentage of the asset’s price. $2.50 • If an asset’s price is $50 and it pays $2.50 in interest, the interest rate is 100 = 5.0 $50.00 percent.

• If the price of the asset rises, the interest rate falls. Conversely if the interest rate falls, the price of the asset rises.

It is helpful to show explicitly how the market price of a bond is determined by the current interest rate.

Using an example of government bond will be useful for future chapters on monetary and fiscal policy.

Explain that a bond is an “IOU” from the issuer and its basic components of are its term, face value and coupon payment. For example, a bond might have a $10,000 face value with a coupon payment of $500 for the next 5 years. Point out to your students that this coupon payment means that the bond is essentially paying an interest rate of 5 percent for the next five years…at least as long as its price is $10,000. Explain how the bond can be traded in the secondary market and ask them what they think the bond’s price would be if the market interest rate rose to 6 percent. Make clear that when the interest rate rises to 6 percent, which means that “new” government bonds with a $10,000 face value will sell for $10,000 and will pay a $600 coupon payment. Your students should be able to see that the “old” bond must be worth less than the new bond because the old bond has a smaller coupon payment. Tell your students that while it is possible to determine the precise price for which the old bond will trade, your key point is that the price has fallen from $10,000 to something less. In other words, an increase in the interest rate has lowered the price of (old) bonds!

The Real Interest Rate •

The nominal interest rate is the number of dollars that a borrower pays and a lender receives expressed as a percentage of the number of dollars borrowed or lent. The real interest rate is the nominal interest rate adjusted to remove the effects of inflation on the buying power of money. The real interest rate is approximately equal to the nominal interest rate minus the inflation rate. The real interest rate is the opportunity cost of loanable funds.

Giving a numeric example of why the real interest rate and nominal interest rate differ can be enlightening for your students. Suppose you have $100 this year and you can invest it at a (nominal) interest rate of 10 percent. One year later you will have $110, that is, 10 percent more dollars. If the price of a cheeseburger is $1 this year you can buy 100 cheeseburgers. But if one year later the price level rose from 100 to 108 .

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and the price of cheeseburgers rose at this average rate, then the cheeseburgers will cost you $1.08. Next year your $110 will only buy about 102 cheeseburgers ($110/$1.08). The purchasing power of your 10 nominal interest rate is only about 2 more cheeseburgers, a 2 percent real interest rate!

Real versus nominal interest rate. To drive home the distinction between the nominal interest rate and real interest rate, ask your class if an interest rate of 10 percent is high. Almost assuredly they will respond with a resounding “Yes.” Point out to them that around 1980 a 10 percent interest rate was exceedingly low. At the time a typical interest rate was between 12 percent and 17 percent, depending on the riskiness of the asset and the length of the loan. What accounts for the difference between then and now? The answer is simple: inflation. In 1980 the inflation rate was running at more than 10 percent per year. Given the high inflation rate, the nominal interest rate adjusted so that it, too, was high. Most of the dollars lenders received as (nominal) interest went to keeping their purchasing power intact. But the real interest rate at that time was not much different than the real interest rate nowadays. In other words, the increase in purchasing power received by lenders (the real interest rate) in the 1980s was about the same as the increase in purchasing power received by lenders today.

III. The Loanable Funds Market The loanable funds market is the aggregate of all the individual financial markets. In this market households, firms, governments, banks, and other financial institutions lend and borrow.

The Demand for Loanable Funds •

• •

•

The quantity of loanable funds demanded is the total quantity of funds demanded to finance investment, the government budget deficit, and international investment or lending during a given time period. Business investment makes up the majority of the demand for loanable funds and so the initial focus is on investment.

Investment depends on the real interest rate and expected profit. Firms will make the investment only if they expect to earn a profit.

The demand for loanable funds is the relationship between the quantity of loanable funds demanded and the real interest rate when all other influences on borrowing plans remain the same.

• The real interest rate is the opportunity cost of loanable funds, so there is a negative relationship between the quantity of loanable funds demanded and the real interest rate.

• Investment is influenced by expected profit. The higher the expected profit, the more investment firms make. Expected profit rises during a business cycle expansion and falls during a business cycle recession; rises when technology advances; rises as the population grows; and fluctuates with swings in business optimism and pessimism.

The demand curve for loanable funds is downward sloping as shown in the figure. The demand for loanable funds increases when investment increases, so when expected profit increases, the demand for loanable funds increases and the demand for loanable funds curve shifts rightward.

The Supply of Loanable Funds • • • •

The quantity of loanable funds supplied is the total quantity of funds available from private saving, the government budget surplus, and international borrowing during a given time period. Saving makes up the majority of the loanable funds available, so the initial focus is on saving.

The supply of loanable funds is the relationship between the quantity of loanable funds supplied and the real interest rate when all other influences on lending plans remain the same.

When the real interest rate rises, saving increases so the supply of loanable funds increases. As illustrated in the figure, the supply of loanable funds curve is upward sloping.

Saving and hence the supply of loanable funds increases when disposable income increases, when wealth decreases, when expected future income decreases, and when default risk decreases. When the supply of loanable funds increases the supply curve of loanable funds curve shifts rightward. .

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Equilibrium in the Loanable Funds Market •

As the figure shows, the equilibrium real interest rate sets the quantity of loanable funds demanded equal to the quantity of loanable funds supplied. In the figure, the equilibrium real interest rate is 5 percent and the equilibrium quantity of loanable funds is $2.0 trillion.

Changes in Demand and Supply •

Changes in either demand or supply change the real interest rate and the price of financial assets.

• If expected profit increases the demand for loanable funds increases. The equilibrium real interest rate rises and the equilibrium quantity of loanable funds and investment increase.

• If the supply of loanable funds increases, the equilibrium real interest rate falls and the equilibrium quantity of loanable funds and investment increase.

• Short-run changes in the demand and supply can be sharp so that changes in the real interest rate also can be sharp. But in the long run the demand and supply grow at the same pace so there is no upward or downward trend in the real interest rate.

•

An Economics in Action feature shows that households supply 43 percent of the $180 trillion of loanable funds while firms demand 56 percent of the loanable funds

•

The Economics in Action feature uses the loanable funds market to examine the home price bubble that helped lead to the financial crisis. Between 2001 and 2005, a massive increase in the supply of loanable funds lowered the real interest rate and led to many people purchasing homes.

As the price of homes rose, the demand for loanable funds increased to try to take advantage of the price rise. The increase in the demand increased the real interest rate, which put many homeowners in financial difficulty and ultimately lead to defaults and foreclosures.

IV. Government in the Loanable Funds Market A Government Budget Surplus •

Changes in the government surplus can shift the supply of loanable funds curve. In the figure, PSLF is the private supply of loanable funds curve. The government has a budget surplus equal to the length of the arrow ($0.4 trillion). The surplus adds to private saving and so the supply of loanable funds curve becomes SLF. Without the budget surplus, the real interest rate is 6 percent and the quantity of loanable funds and investment is $2.0 trillion; with a budget surplus, the real interest rate is 5 percent and the quantity of loanable funds and investment is $2.2 trillion.

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A Government Budget Deficit •

• •

Changes in the government deficit can shift the demand for loanable funds curve. In the figure, PDLF is the private demand for loanable funds curve. The government has a budget deficit equal to the length of the arrow ($0.4 trillion). The deficit adds to private demand and so the demand for loanable funds curve becomes DLF. Without the budget deficit, the real interest rate is 5 percent and the quantity of loanable funds and investment is $2.0 trillion; with the budget deficit, the real interest rate is 6 percent, the quantity of loanable funds is $2.2 trillion, and investment is $1.8 trillion.

The tendency for a government budget deficit to decrease investment is called a crowding-out effect.

The possibility that a budget deficit increases private saving supply in order to offset the increase in the demand for loanable funds is called the Ricardo-Barro effect. The reasoning behind this effect is that taxpayers will save to pay higher future taxes that result from the deficit.

To the extent that the Ricardo-Barro effect occurs, it reduces the crowding-out effect because the SLF curve shifts rightward to offset the deficit.

The Economics in the News section examines how interest rates on corporate securities fell during 2017.

The analysis points out that the supply of loanable funds increased while the demand did not change.

These changes lowered the real interest rate.

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Additional Problems 1.

Government expenditure decreases by $100 billion. a. If there is no Ricardo-Barro effect, explain how loanable funds, saving, investment, and the real interest rate respond to this fiscal policy. b. How does your answer in part a depend on the strength of the Ricardo-Barro effect?

2.

Figure 7.1 shows the market for loanable funds.

The government is running a budget surplus of $900 billion. a. Show the effect of a $400 billion decrease in the government budget surplus if there is no Ricardo-Barro effect. How much investment is crowded out by the fall in the surplus? b. How does the Ricardo-Barro effect change the results?

3.

IMF Warning Over Slowing Growth Turmoil in the world’s financial markets may well slow global economic growth.

BBC News, October 10, 2007 Explain how turmoil in global financial markets might affect the demand for loanable funds, investment, and global economic growth in the future.

Solutions to Additional Problems 1.

a.

b.

The decrease in government expenditure by $100 billion increases the supply of loanable funds, which increases the equilibrium quantity of loanable funds. Compared to what otherwise would have been the case, the decrease in government expenditure lowers the real interest rate and increases investment.

The stronger the Ricardo-Barro effect, the less the increase in the supply of loanable funds as taxpayers expect future taxes to be lower due to the decrease in government expenditures. The smaller the increase in the supply of loanable funds, the smaller the changes in loanable funds, the real interest rate, and investment.

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2.

3.

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a.

Figure 7.2 shows the effect of the $400 billion decrease in the government surplus. The government deficit decreases saving by $400 billion and so shifts the supply of loanable funds curve leftward by $400 billion. As the figure shows, the equilibrium real interest rate rises from 5 percent to 6 percent and the equilibrium quantity of loanable funds decreases from $2.0 trillion to $1.8 trillion. So the $400 billion decrease in surplus crowds out (decreases) $200 billion of investment. b. The Ricardo-Barro effect says that people change their saving to offset the effect of changes in the government budget balance. In the extreme, people increase their saving by the full amount of the decrease in surplus, in which case the supply of loanable funds curve does not shift and so investment and the real interest rate do not change. In a less extreme case, the saving increase offsets only some of the decrease in surplus, so the supply of loanable funds curve still shifts leftward, but by a smaller amount. As a result, the real interest rises less and investment decreases less that they would in the absence of the Ricardo-Barro effect.

The turmoil in financial markets leads some people to decrease their saving because of fear that they might lose these funds due to the turmoil; in other words, default risk increases. As a result, the supply of loanable funds decreases, which pushes up the real interest rate. The primary source demanding loanable funds is business firms who want these funds to make investment. If the real interest rate rises, the quantity of loanable funds demanded decreases as businesses cancel nolonger profitable investments. With less investment there will be less capital and so the growth in potential GDP slows.

Additional Discussion Questions 11. What is the difference between “insolvency” and “illiquidity”? Insolvency occurs when a firm has negative net worth; that is, the firm’s liabilities—what it owes—exceed the firm’s assets—what it owns. Illiquidity occurs when a firm does not have enough cash to meet a sudden demand for repayment of what it has borrowed. The situations are different: A firm can be insolvent and liquid. A firm can also be solvent and illiquid.

12. Explain why and how investment depends on the real interest rate. The real interest rate is the opportunity cost of investment. A firm that borrows funds to make an investment faces the real interest as the opportunity cost of its investment because the real interest rate determines the purchasing power—the amount of goods and services—that a firm must repay on its loan. A firm that uses its own funds to make an investment also faces the real interest rate as the opportunity cost of its investment because the firm could loan the funds to others and collect as its return the real interest rate. Because the real interest rate is the opportunity cost of investment, an increase in the real interest rate decreases the quantity of investment firms demand.

13. If the actual real interest rate differs from the equilibrium real interest rate, what forces drive the real interest rate to the equilibrium real interest rate? If the real interest rate is higher than the equilibrium real interest rate, there is a surplus of loanable funds. In this case lenders cannot loan all the funds they want. In order to loan their funds, .

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loaners reduce the real interest rate they charge and the real interest falls to the equilibrium real interest rate. If the real interest rate is lower than the equilibrium real interest rate, there is a shortage of loanable funds. In this case borrowers cannot borrow all the funds they want. In order to borrow their funds, borrowers raise the real interest rate they will pay and the real interest rises to the equilibrium real interest rate.

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8

MONEY, THE PRICE LEVEL, AND INFLATION**

The Big Picture Where we have been: Chapters 6 and 7 focused on the markets for labor and capital, both real resources used in the production of real GDP. This chapter now shifts gears to study money and how money impacts markets. Because Chapter 8 is the first chapter on money, it introduces a lot of new material. The discussion of the market for money relates back to the supply and demand model in Chapter 3.

Where we are going: Chapter 8 is the first of two chapters that examine money and the economy. This chapter defines money, introduces the Federal Reserve, explains the money creation process, and then concentrates on the long run effects (the quantity theory) of changes in the quantity of money. Chapter 14 returns to these topics to study monetary policy. Chapter 8 also is the 3rd of 4 chapters that cover the economy in the long run. The next chapter looks at the exchange rate and balance of payments.

New in the Thirteenth Edition An important change for you to take note of for your lecture notes is that “Excess Reserves” is now called “Unplanned Reserves” which is defined the same way it was before (Actual Reserves – Desired Reserves). The data and figures in the chapter are updated to reflect 2017 data. The Economics In The News feature has a 2016 article about how Americans (even Millennials) still use cash as favored means of payment. Five new end-of-chapter exercises were added regarding new news clips in this edition

*

* This is Chapter 25 in Economics. .

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Lecture Notes

Money, the Price Level, and Inflation • • • •

I.

Money is anything that is used as a means of payment.

Banks play a major role in creating money but this process is ultimately controlled by the Federal Reserve.

In the short run, equilibrium in the money market determines the nominal interest rate.

In the long run, an increase in the growth rate of the quantity of money leads to a higher inflation rate.

What Is Money?

The contrast between money in economics and money in everyday language. It can be helpful to emphasize that “money” is a technical term in economics that has a precise meaning and that differs from its looser usages in everyday language. For example, an economist would not say “Bill Gates makes a lot of money.” Rather, the economist would say “Bill Gates earns a large income.” An interesting exercise is to have students think of statements containing the word “money” that make complete sense in normal language but that misuse the word in its precise economic sense, and to get them to explain why.

•

Money is any commodity or token that is generally acceptable as a means of payment. A means of payment is a method of settling a debt. Money has three functions: • Medium of exchange • Unit of account • Store of value

Medium of Exchange A medium of exchange is any object that is generally accepted in exchange for goods and services.

Money acts as a medium of exchange. As a result, money eliminates the need for barter, which is the exchange of goods and services directly for other goods and services.

The defining characteristic of money. Adam Smith wrote, “Money is a commodity or token that everyone will accept in exchange for the things they have to sell.” Most people have interpreted this statement as defining money as the medium of exchange. That interpretation is wrong. Smith is defining money as the means of payment. Money is a commodity or token that everyone will accept as payment for the things they have to sell.

When Michael Parkin was a young economist, he had the enormous good fortune to meet Anna Schwartz, Milton Friedman, and a group of other leading monetary economists. It was during the late 1960s when the monetarist debate was alive and well and people were still arguing about whether the demand for money was interest inelastic (as the monetarists claimed) or almost perfectly elastic (as the Keynesians claimed). Anna made a remark that for Michael was one of those defining moments. She said money is the means of payment. Nothing else performs this function. It is unique to money. Many things serve as a medium of exchange, unit of account, or store of value, but money alone serves as the means of payment— the means of settling a debt so that there is no remaining obligation between the parties to a transaction.

Get the class involved in figuring out what money is. To involve the students in the process of determining what money is, after noting its definition and three functions, ask them what they think should be counted as money. List the suggestions on the board before commenting on them. Coins and currency will certainly be mentioned. Usually each class has a few members who have read the text and will suggest checkable deposits. Almost always you will obtain some not-so-excellent answers, ranging from gold to shares of stock to credit cards. .

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The point of this exercise is to obtain these incorrect answers because they give you a chance to discuss why these items are not money. Without ridiculing the wrong answers, you might point out that students rarely pay for books by giving the bookstore shares of IBM stock and asking for change in AT&T stock. By being involved and having to think, the students emerge with a stronger grasp of why money is measured as it is.

Unit of Account Money serves as a unit of account, which is an agreed measure for stating the prices of goods and services.

Store of Value Money serves as a store of value because it can be held and exchange later for goods and services.

During the Great Depression there was deflation so the real return on money was positive. Thus, many people held money as an asset and did not immediately use it to spend on goods and services. This is the idea behind Keynes’ concern that people were stuffing money in their mattresses instead of spending it.

Concerns about deflation have been revived in recent years. Japan has had deflation on and off for the past decade and many other countries have very low rates of inflation. One of the more interesting suggestions

by Fed economists in thinking how to avoid the problem of money serving so well as a store of value is to have money which expires like a coupon. It is not clear whether such a form of money is feasible from a political or psychological point of view, but the suggestion is interesting.

Money in the United States Today • • •

•

Money consists of currency (the notes and coins held by individuals and businesses) and deposits at banks and other depository institutions. Deposits are also money because they can be converted into currency and because they are used to settle debts.

M1 consists of currency and traveler’s checks plus checking deposits owned by individuals and businesses.

M2 consists of M1 plus time deposits, saving deposits, and money market mutual funds and other deposits. M2 is much larger than M1, $11,423 billion versus $2,857 billion in June, 2014. M2 includes liquid assets that are not means of payment. Liquidity is the property of being instantly convertible into a means of payment with little loss in value. The assets in M2 are generally quite liquid.

Checks are not money—they are instructions to transfer money from one person’s deposits to another person’s deposits. Credit cards are not money—they are IDs that allow an instant loan.

Fiat money. Pull out a dollar bill, wave it at the class and ask, “What backs our currency?” You should get someone to state gold. Tell them, “Yes, I have heard about all the gold stored in Fort Knox, but none of it is there for a trade-in value. We went off the gold standard with Nixon. If you look closely at the bill you’ll find your backing, “In God we trust,” That’s it! The dollar has value because of your faith that someone else will accept it for something else you want. Alternatively (or additionally) take a green piece of paper and cut it to the same size as a dollar bill. Then take the paper into class along with a dollar bill. Ask the students why one piece of paper has value and the other does not. Is there anything intrinsically more valuable about the dollar bill? If not, why won’t someone in class exchange his or her old wrinkled piece of green paper with writing on it for the nice new piece you offer?

II. Depository Institutions •

A firm that takes deposits from households and firms and makes loans to other households and firms is called a depository institution. There are three types of depository institutions whose deposits are money: commercial banks, thrift institutions, and money market mutual funds.

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Commercial Banks • •

A commercial bank is a firm that is licensed to receive deposits and make loans. In 2014 there are about 6,800 commercial banks but that number has been trending downward. The deposits of commercial banks account for 50 percent of M1 and 71 percent of M2.

Banks accept deposits and then divide these funds into reserves (cash in the vault plus its deposits at the Federal Reserve), liquid assets (such as Treasury bills and commercial bills), securities (such as U.S. government bonds and mortgage-backed securities), and loans (made primarily to corporations for purchases of capital equipment and to households to finance homes, consumer durable goods, and credit cards). Loans are the riskiest of a bank’s assets. As a percentage of deposits, on June 30, 2014 cash assets were 28.0 percent, securities were 27.6 percent, and loans were 75.4 percent. (The percentages sum to more than 100 percent because deposits are just one source of funds; borrowing and the banks’ own capital are other sources of funds and are equal to about 50 percent of deposits.)

Because of concerns about the financial crisis and bank runs, banks increased their reserves from the more typical 0.6 percent of deposits in June 2008 to 14.3 percent in June, 2010 and to 28.0 percent in June, 2014.

Thrift Institutions The thrift institutions are savings and loan associations, savings banks, and credit unions.

Money Market Mutual Funds A money market mutual fund is a fund operated by a financial institution that sells shares in the fund and holds liquid assets such as U.S. Treasury bills and short-term commercial bills.

The Economic Functions of Depository Institutions •

Depository institutions make a profit from the spread on the interest rate at which they lend over the interest rate they pay on deposits. The spread reflects four services provided by depository institutions: • Create Liquidity: Most assets are less liquid than liabilities, so depository institutions turn lessliquid funds into more liquid funds.

A bank run is a liquidity crisis in the sense that banks can have the deposits backed by assets such as mortgage loans, but the assets are less liquid than the deposits. This scenario should be familiar to anyone who has seen It’s a Wonderful Life with Jimmy Stewart. As suggested by the movie, bank runs were a big problem in the 1930s and many economists believe they made the Great Depression much worse than other recessions. Indeed, banks runs were feared by the Federal Reserve during the financial crisis of 2008 and this fear likely accounted one reason why the Fed responded so strongly to the crisis.

• • •

Lower the Cost of Borrowing Obtaining Funds: Depository institutions lower transaction costs of matching borrowers and lenders.

Lower the Cost of Monitoring Borrowers: Depository institutions lower transaction costs by specializing in monitoring risky loans.

Pool Risk: The costs of defaults on loans are spread across all depositors, instead of being borne by individual lenders.

What do banks do? Students usually have bank accounts, but often they have never fully thought through what banks do, how they do it, or what the differences are between banks and other deposit-taking institutions, so what tends to strike instructors as rather dry descriptive material can be interesting to students. It is worth being explicit about the fact, which students tend to be very aware of, that in practice commercial banks earn income not only by the spread between their deposit and lending rates, but also by charging fees for their services. The text focuses on the role of depository institutions as a source of credit .

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creation; for most students, like most customers, their most important function is actually facilitating the payment process, and a little discussion on that (and how relatively cheap it is) can also engage students.

Financial Innovation •

The development of new financial products is called financial innovation. Some innovation has been a response to economic circumstances such as high inflation and high interest rates in the 1970s. Others, such communications networks which have spread the use of credit cards, are the result of advances in technology. Still others, such as sub-prime mortgages, were developed during the 2000s.

III. The Federal Reserve System The central bank of the United States is the Federal Reserve System. A central bank is a bank’s bank and a public authority that regulates a nation’s depository institutions and controls the quantity of money. The Fed conducts the nation’s monetary policy, which means that it adjusts the quantity of money in circulation.

By adjusting the quantity of money, the Fed can change interest rates.

Conspiracy theory of the Fed. Some students will have heard about a “conspiracy theory of the Fed.” This theory, advanced by the ignorant, the misinformed, or the deceitful, is that the commercial banks own the Fed, which is run solely to benefit the banks to ensure that they earn large profits. Point out that commercial banks do indeed own the Fed—they own all the stock issued by the Fed. But Fed stock is not like shares in General Electric or Microsoft. The dividend on the Fed’s stock is fixed at 6 percent of the purchase price, and the stock cannot be sold in a marketplace. So this stock is a lousy investment.

What privileges come with the stock? Commercial banks elect six of the nine directors of their Federal Reserve Regional bank; each commercial bank has the same number of votes regardless of the amount of stock it owns. But the directors of the regional banks are hardly key players in the Federal Reserve System.

Essentially, the most important task they perform is nominating a president for the regional bank. The regional banks’ presidents are important. The directors, however, do not get much freedom in this choice because their nominee must be approved by the Board of Governors, which does not hesitate to veto anyone considered unacceptable.

Regional bank presidents gain their power from sitting on the FOMC. But there they are a minority because the voting members of the FOMC consist of five regional bank presidents and seven members of the Board of Governors. Because the board members are appointed by the president and approved by the Senate, the government thus wields the ultimate power in the Federal Reserve. The regional bank presidents must be approved by the publicly appointed board members and the board members constitute a majority on the FOMC.

The Structure of the Fed • • •

The Board of Governors has seven members, including the chairman (currently Ben Bernanke).

There are 12 regional Federal Reserve banks.

The Federal Open Market Committee (FOMC) is the main policy-making group of the Fed. It is comprised of the members of the Board of Governors and the Presidents of the regional Federal Reserve Banks. The Board of Governors, the President of the Federal Reserve Bank of New York, and, on a rotating basis, the presidents of four other regional Federal Reserve Banks, vote on monetary policy. In practice, the chairman has the largest influence on policy.

The Fed’s Balance Sheet • •

The Fed’s two main assets are U.S. government securities and loans to depository institutions.

The Fed’s two main liabilities are Federal Reserve notes (currency) and banks’ deposits.

The Economics in Action detail discusses how the Fed’s balance sheet changed dramatically as a result of the financial crisis in 2008. U.S. government securities soared from less than $1,000 billion to

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approximately $2,500 billion and currency from less than $1,000 trillion to approximately $1,300 trillion.

Banks now hold almost $3,000 billion reserves. The monetary base quadrupled in size!

•

The monetary base is the sum of coins, Federal Reserve notes, and depository institution deposits at the Fed. The major parts of the monetary base, Federal Reserve notes and depository institution deposits, are liabilities of the Federal Reserve. Changes in the monetary base lead to changes in the quantity of money.

The Fed’s Policy Tools •

•

•

Required Reserve Ratios: The minimum percentage of deposits that depository institutions must hold as reserves are the required reserve ratios. The Fed sets the required reserve ratio. A decrease leads to an increase in the quantity of money and an increase leads to an increase in the quantity of money.

Last Resort Loans: The Fed is the lender of last resort, which means that if depository institutions are short of reserves, they can borrow from the Fed. The interest rate charged on these loans is the discount rate. In 2008 the Fed changed its policy and encouraged depository institutions to borrow from it. A decrease in the discount rate leads to an increase in the quantity of money and an increase in the discount rate leads to a decrease in the quantity of money.

Open Market Operation: An open market operation is the purchase or sale of government securities by the Federal Reserve System in the open market. The Fed does not directly purchase bonds from the federal government because it would appear that the government was printing money to finance its expenditures. An open market purchase leads to an increase in the money supply.

IV. How Banks Create Money Creating Deposits by Making Loans When a bank makes a loan, it makes a deposit to finance the loan. Because deposits are money, the bank has created money. For example, if you use a credit card to buy $50 at Walgreens, loans to you increase and Walgreens deposits increase. The increase in deposits increases the quantity of money. Three factors limit the amount of deposits that the banking system can create: •

•

•

•

The monetary base: Banks have a desired amount of reserves they want to hold and people have a desired amount of currency. The monetary base sets a limit on the sum of these two. Both of these desired holdings depend on the quantity of money, and so the monetary base limits the amount of money that can be created. Alternatively, the monetary base limits the amount of the banking systems’ reserves.

Desired reserves: A bank’s actual reserves are the coin and currency in its vault and its deposits at the Federal Reserve. The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio. The desired reserve ratio is the ratio of reserves to deposits that banks want to hold. Actual reserves minus desired reserves are unplanned reserves. Unplanned reserves can be loaned and can thereby create money.

Desired currency holding: The other use of the monetary base involves the public’s holding it as currency. When banks create new money by creating new deposits, the public wants to hold some of this money as currency. As a result, currency leaves the banking system when banks increase their loans, which limits the overall increase in loans. The currency drain is the ratio of currency to deposits.

Banks use unplanned reserves to make loans. In the process, banks create money.

• For each dollar deposited, a bank keeps a fraction as reserves and lends out the rest. When a bank makes a loan, it creates a new deposit (new money) equal to the value of the loan. After the loan is spent by the borrower, the new money eventually ends up back as a new deposit in a bank. As new deposits are made, the process of money creation begins again, albeit with a .

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smaller amounts each time because banks keep a fraction of each deposit in the form of reserves.

The total of amount of new money created by the entire banking system depends on the fraction of the deposits that banks loan at each step in the process.

The Money Creation Process • • •

• •

The monetary base increases and banks have unplanned reserves. Banks lend the unplanned reserves and thereby create new deposits, that is, create new money.

The new money is used to make payments. Some of the new money remains in the banking system as deposits and some of it is drained out of the banking system via the currency drain.

The funds that stay within the banking system are reserves for the banks. Because deposits have increased, banks’ desired reserves have increased. But the actual reserves have increased by more than desired reserves, so banks still have unplanned reserves to loan. Banks lend these unplanned reserves and the process continues.

Eventually the money creation process comes to a stop when the sum of additional currency holdings plus additional desired reserves equals the initial increase in the monetary base and banks’ reserves.

The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. It determines the change in the quantity of money that results from a given change in the monetary base. A change in the monetary base has a multiplied effect on the quantity of money because banks’ loans are deposited in other banks where they are loaned once again. The formula for the money multiplier is derived in the Mathematical Note to the chapter (see the end of these lecture notes).

A money creation experiment. The process through which banks “create money” can be a dark and mysterious secret to the students. Indeed, even though the text contains a superb description of the process, students still manage to end up confused.

The first prerequisite to students understanding the process is that they be comfortable with balance sheets shown in the form of T-accounts, and it is well worth spending time on them to make sure students understand what they are and what they show. This will be the first time some students have ever had to interpret a balance sheet, and it is key that they understand that assets are what are owned, liabilities are what are owed, by the institution for which the balance sheet is constructed; and that the two sides must balance.

Mark Rush (our supplements czar) tackles the problem of getting students to understand bank money creation head-on by (again) involving the class in a demonstration. Prepare by decorating a piece of green paper with currency-like symbols. (For instance, Mark draws a seal and around it writes “In Rush We Trust.” You may write the same slogan, but substituting your name for his probably will be more effective; an alternative is to use “play money.”) Label this piece of paper a “$100 bill.”

In class use one of the students by handing him the bill. Tell him that he has decided to deposit it in his bank and ask him his bank’s name. On the chalkboard draw a balance sheet for the bank with deposits of $100, reserves of $10, and loans of $90. Tell the students that the desired reserve ratio is 10 percent, so this bank currently has no unplanned reserves. Now, instruct the student to deposit the money in his bank, which coincidentally happens to be run by the student next to him. Show the class what happens to the balance sheet and how the bank now has unplanned reserves of $90.

Clearly the “banker” will loan these reserves to the next student in the class, who wants a $90 dollar loan so she can take a bus ride to some nearby dismal location. (Being located in Gainesville, Florida, Mark picks on the city of Stark, home to Florida’s electric chair and a town with an apt name.) When the loan takes place, rip the $100 bill so that only about nine tenths of it is given as the loan. This student pays the money to Greyhound—coincidentally the next student. Ask the name of Greyhound’s bank and draw an initial balance sheet for this bank identical to the initial balance sheet of the first bank. Greyhound deposits the money in the bank—the next student in the row. .

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Work with the balance sheets to show what happens to the first bank and what happens to the second bank. Clearly the first one no longer has unplanned reserves but the second bank now has $81 of unplanned reserves ($90 of additional deposits minus $9 of desired reserves). The second bank will make a loan, which you can act out with more students in the class, again ripping off nine tenths of the remaining bill. Work through the point where the second loan winds up deposited in a third bank and then stop to take stock. At this point the quantity of money has increased by $90 in the second bank and $81 in the third, for a total increase—so far—of $171. The students will see that this loaning and reloaning process is not yet over and that the quantity of money will increase by still more. Moreover (and more important) the students will grasp how banks “create money.”

An Economics in the News detail defines, describes, and analyzes QE2, that is, the second round of quantitative easing the occurred in 2011.

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V. The Money Market A picky point. The textbook is careful to distinguish the term “money supply” and the “quantity of money.”

The term “money supply” is reserved for the relationship between the quantity of money and the interest rate, other things remaining the same. It parallels the demand for money. Although this point might seem picky, you can help your students by using this same language convention.

The Influences on Money Holding The demand for money refers to the choice to hold an inventory of money, not to the desire to receive money. The quantity of money that people plan to hold depends on: •

• • •

The Price Level: The quantity of nominal money demanded is proportional to the price level so that, for example, when the price level doubles, the quantity of nominal money demanded doubles.

• Real money is the quantity of money measured in constant dollars and equals nominal money divided by the price level. The quantity of real money demanded is independent of the price level.

The Nominal Interest Rate: The nominal interest rate is the opportunity cost of holding money, so an increase in the nominal interest rate decreases the quantity of real money demanded.

Real GDP: An increase in real GDP increases the quantity of money people plan to hold.

Financial Innovation: Some financial innovation decreases the quantity of money people plan to hold (ATM machines) and other financial innovation increases it (interest paid on checking accounts).

The Demand for Money Curve The demand for money curve is the relationship between the quantity of real money demanded and the interest rate, holding all else equal. As the figure shows, the negative relationship between the interest rate and the quantity of money demanded means the demand for money curve is downward sloping.

Shifts in the Demand for Money Curve •

A change in real GDP or financial innovation changes the demand for money and shifts the demand for money curve. An increase in real GDP increases the demand for money and shifts the demand for money curve rightward.

The Demand for Money Students are often confused by the phrase “demand for money” and it is worth tackling it head-on by emphasizing this does not equate to “wanting to be rich,” but refers to how much of total wealth (assets) the public want to hold in the particular form of “money.” Students often find it straightforward to think about their behavior and the quantity of cash they hold in their wallet when dealing with the factors that change the demand for money and shift the demand for money curve. But they frequently get confused about the effect the interest rate has on the quantity of money demanded, probably because their holdings of money are not large. So tell your students to imagine themselves in the job of treasurer of a corporation with large liquid resources and to think how their behavior with respect to those funds might differ according to the short-term interest rates available on non-money alternatives, .

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such as bonds. It is easier for them to see that a treasurer will surely shift $5 million dollars into nonmoney assets in order to reap the higher interest-rate reward when the interest rate rises.

Money Market Equilibrium Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied.

The quantity of money supplied is determined by the Federal Reserve.

•

•

•

Short Run: On any given day, the quantity of real money is fixed, so the supply of money curve is vertical. The nominal interest rate adjusts to establish equilibrium in the money market. The equilibrium nominal interest rate equates the quantity of real money demanded with the fixed quantity of real money. In the figure, the equilibrium interest rate is 5 percent.

The Short-Run Effect of a Change in the Supply of Money: Starting from a short-run equilibrium, if the Fed increases the quantity of money, people hold more money than the quantity demanded.

With a surplus of money holding, people enter the loanable funds market and buy bonds. The increase in demand for bonds raises the price of a bond and lowers the interest rate.

Long Run: In the long run, supply and demand in the loanable funds market determines the equilibrium real interest rate. That, plus the expected inflation rate determines the nominal interest rate, so the nominal interest rate cannot adjust to restore equilibrium in the money market. The factor that adjusts in the long run is the price level: The price level adjusts to make the real quantity of money equal to the real quantity of money demanded. In the long run, an increase in the quantity of money raises the price level by the same proportion.

VI. The Quantity Theory of Money • • •

The quantity theory of money is the proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP. Nominal GDP equals real GDP, Y, multiplied by the price level, P, or GDP=PY. So the velocity of circulation, V, is given by V = PY/M. The equation of exchange states that the quantity of money, M, multiplied by the velocity of circulation, V, equals GDP: MV = PY. The equation of exchange is a definition and so is always true.

It becomes the quantity theory of money by adding two assumptions: • The velocity of circulation is not influenced by the quantity of money.

• Potential GDP is not influenced by the quantity of money.

Checkout this 3:27 minute YouTube video that shows the equation of exchange in a nice simple format. On YouTube, search “Quantity Theory of Money” and select the video created by Marginal Revolution.

•

The equation of exchange can be rearranged as P = M(V/Y). This equation, together with the assumptions about velocity and potential GDP, implies that in the long run, the price level is determined by the quantity of money.

• In growth rates, the equation of exchange is: (Money growth rate) + (Growth rate of velocity) = (Inflation rate) + (Real GDP growth rate). Rearranging this equation gives (Inflation rate) = (Money growth rate) + (Growth rate of velocity) − (Real GDP growth rate). If velocity does not .

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grow, then in the long run the inflation rate equals the growth rate of the quantity of money minus the growth rate of potential GDP. Historical Insight. When Milton Friedman’s quantity theory of money was brought to the attention of policymakers during the 1960s, he was labeled an ivory tower academic with his head in the clouds. When his predictions of inflation came true in the 1970s, he was crowned king of monetary theory.

Evidence on the Quantity Theory of Money The predictions of the quantity theory can be tested using evidence on money growth and inflation across time. On the average, the money growth rate and the inflation rate are correlated, supporting the quantity theory. The predictions of the quantity theory also can be tested using the evidence on money growth and inflation across countries. As predicted, rapid money growth is correlated with high inflation.

The idea that growth in the quantity of money causes inflation sounds obvious enough to students that they might miss just how controversial the idea is, at least outside of the economics profession. In an economy suffering from inflation, many observers blame “special circumstances,” such as hikes in the price of oil, bad crop harvests, import prices, or whatever. Economists from the central bank often lend their support to these assertions. The fact that central bank employees wish to divert attention away from their role in creating inflation is understandable if not commendable. But why do other observers go astray? Most often it is because they look at only their economy and do not consider what data from other economies indicates or data from their own economy over a long period of time shows. When looking at only one economy and one time period, it is always possible to find some price-increasing factor other than growth in the quantity of money and blame inflation on it. But when looking across economies or across time, the paramount role growth in the quantity of money plays in creating inflation is immediately apparent. So, contrary to the assertions emanating from the central banks and other analysts in nations with high inflation, almost surely their inflation is the result of high monetary growth and not some other “special, unique to them, unique to this time period circumstance!”

The Economics in the News section deals with banks preparing for deposit outflows in 2015 with the Fed relaxing quantitative easing. It uses the demand for M2 money to derive an estimate of what will be the deposit outflow when interest rates return to more normal levels.

MATHEMATICAL NOTE The mathematical note derives the formula for the money multiplier.

•

Money is M, deposits is D, and currency is C. M=D+C

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The monetary base is MB and banks’ reserves is R. MB = C + R

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The money multiplier, mm, is equal to mm = M/MB = (D + C)/(R + C)

•

Divide all the variables on the right side of the money multiplier equation by D: mm = (1 + C/D)/(R/D + C/D)

• •

C/D is the currency drain ratio and R/D is the banks’ reserve ratio.

The formula shows that the size of the money multiplier depends on the reserve ratio and the currency drain.

In 2008, when times were more “normal,” for M1 the currency drain ratio, C/D, was equal to 1.24

•

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1 + 1.24 = 0.28 + 1.24 1.47. In 2008, for M2 the currency drain ratio was equal to 0.12 and the reserve ratio was equal to 1 + 0.12 0.03, so the money multiplier for M2 was = 7.5.

0.03 + 0.12 In 2014, when banks are holding substantially more reserves than in past decades, for M1 the currency drain ratio, C/D, is equal to 0.81 and the reserve ratio, R/D, is equal to 1.69, so the money 1 + 0.81 multiplier for M1 was = 0.72. In 2014, for M2 the currency drain ratio is equal to 0.13 1.69 + 0.81 1 + 0.13 and the reserve ratio is equal to 0.26, so the money multiplier for M2 was = 2.90.

0.126 + 0.13 and the reserve ratio, R/D, was equal to 0.28, so the money multiplier for M1 was

•

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Additional Problems 1.

Higher Reserve Requirement China’s central bank raised its reserve ratio requirement by one percentage point to 17.5 percent by June 25. China’s action was an attempt to decrease lending growth.

People’s Daily Online, June 11, 2008 a. Compare the required reserve ratio in China and in the United States. d. Explain how raising the required reserve ratio changes the interest rate in the short run and draw a graph to illustrate the change.

2.

In Zimbabwe the growth rate of the quantity of money increased from 52 percent a year to 66,700 percent a year in 2007. Accordingly the inflation rate in Zimbabwe skyrocketed, from 56 percent a year in 2000 to 24,000 percent a year in 2007. The growth rate of real GDP between these years is harder to measure but was probably −30 percent per year. a. How do we know that Zimbabwe’s reported inflation between 2003 and 2007 is almost certainly below the true inflation rate? b. What must be done to stop Zimbabwe’s inflation? c. Zimbabwe’s government frequently responded to its inflation by changing its currency to “knock off” zeros on the currency. At one point it was proposed to knock off ten zeros from the currency (so that an old 10,000,000,000 denomination bill would become a new 1 domination bill). Why will knocking ten zeroes off all prices not stop Zimbabwe’s inflation?

Solutions to Additional Problems 1.

a.

b.

The required reserve ratios in China are much higher than those set by the Federal Reserve. The required reserve ratio is 17.5 percent in China. In the United States, the required reserve ratio is 3 percent of checking deposits between $10.3 million and $44.4 million and 10 percent of these deposits in excess of $44.4 million. The required reserve ratio on other types of deposits is zero.

Figure 8.1 shows the effect of the boost in the required reserve ratio. The increase in the required reserve ratio increases the desired reserve ratio and thus decreases the quantity of money supplied and the money supply curve shifts leftward from MS0 to MS1. As a result, the interest rate rises, in the figure from 4 percent to 6 percent.

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a.

b. c.

We know that the reported inflation rate is too low because the velocity of circulation calculated with it fell. The (true) velocity of circulation rises during hyperinflations as people strive to spend money as rapidly as possible. If the true velocity of circulation rose, then the true inflation rate is higher (probably much higher) than the reported inflation rate.

To stop Zimbabwe’s inflation, the central bank must stop or drastically lower the growth rate of the quantity of money.

Knocking ten zeros off of all prices will not stop Zimbabwe's inflation because it just changes the units in which prices are measured. Prices will continue to grow as long as the quantity of money grows.

Additional Discussion Questions 11. Why is the use of money in the exchange of goods and services less costly than using barter? Barter requires a “double coincidence of wants.” For instance, suppose the first person has good A and wants good B. The person must find a second person with good B and who wants good A. Barter requires that the first person must undertake costly search for his or her trade partner. Use of money, on the other hand, breaks the necessity for the double coincidence of wants. The first person who has good A and wants good B can trade with anyone who wants good A and has money. After exchanging good A for money, the first person can now search for anyone who has good B and wants something else. That person will be willing to accept money in exchange for his or her good B because that person knows that the money can then be exchanged for whatever he or she wants. Therefore money has eliminated the need for the time-consuming and costly search needed with barter.

12. “Everyone knows that true money is issued by the government; that is, the only real form of money is the nation’s currency.” Comment on this assertion. This assertion is false. Money is anything that can be used as a medium of exchange. Funds in checking accounts clearly qualify because they can be used as a medium of exchange. Therefore funds in checking accounts are definitely money. Other sources of funds, such as funds in savings accounts, also come close to be money because they can be used with only slight difficulty as a medium of exchange. Therefore money includes many assets beyond governmentissued currency.

13. Define the monetary base. The monetary base is equal to the sum of coins, Federal Reserve notes, and depository institutions’ deposits at the Federal Reserve. Except for coins, which are a small part of the monetary base, the monetary base is made up of liabilities of the Federal Reserve.

14. “Ask anyone if he or she has enough money. No one ever has enough money, that is, everyone demands more money. Thus theorizing about the demand for money makes no sense because this demand obviously is infinite.” Correct and comment on the error in this assertion. This assertion makes a fundamental error by confusing money with income. Money is M1. The demand for money is the amount of M1 people want to hold.

People have a finite amount of M1 that they want to hold; that is, no one wants to hold an infinite amount of M1. Income, however, is a different story: people would like to receive infinite income because that means that they could have infinite consumption. But infinite income is not the same as holding an infinite quantity of M1!

15. If the price level was already doubling every month and inflation accelerating, what would you expect to happen to the velocity of circulation and why? How close would you expect the relation between the quantity of money and the price level to be? The velocity .

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of circulation would increase. People would try to spend the money they receive as rapidly as possible in order to avoid suffering the loss that comes from higher prices. In this case, which occurs in hyperinflations, the inflation rate exceeds the growth rate of the quantity of money. In a hyperinflation with accelerating inflation, the inflation rate equals the growth rate of the quantity of money plus the growth rate of velocity.

16. How does a currency drain affect the money multiplier? [Requires Mathematical Note] A currency drain decreases the magnitude of the money multiplier. The money multiplier exists because some of the proceeds of the loans that one bank makes are deposited in other banks where it can be loaned once again. The more of the proceeds that are deposited in banks, the larger will be the next round of loans and hence the larger will be the money multiplier. A currency drain decreases the amount of the loans that is deposited back in banks. Because the faction of the loans that is deposited is less, the ultimate increase in the quantity of money—and hence the money multiplier—is smaller.

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C h a p t e r

9

THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS**

The Big Picture Where we have been: Chapter 9 is the last of four that examine the long-run trends of the economy. It uses the quantity theory result from Chapter 8 that in the long run, the price level is determined by the quantity of money. This result is used to show that in the long run, the nominal exchange rate is determined by the quantities of money in the two countries. Chapter 9 also uses the national income accounting identities introduced in Chapter 4 when explaining the balance of payments and, quite importantly, the demand and supply model of Chapter 3 when explaining short-run fluctuations in the exchange rate.

Where we are going: Chapter 9 is the last of the “long-run chapters.” The next section looks at short-run fluctuations. Chapter 10, with its introduction of the aggregate supply/aggregate demand model, is key to understanding short run business cycle fluctuations. The material in this chapter is not prominently featured in future chapters, though it makes a slight recurrence in Chapter 14 when monetary policy is covered. Chapter 15, on International Trade, does not use the material in this chapter directly. However, the global loanable funds market can be used to motivate the models for the global market in goods and services.

New in the Thirteenth Edition The content in this chapter is substantially the same as in the previous edition. Data in tables and graphs have been updated to 2017. The Economics In The News feature has a 2017 analyzing some of Trump’s rhetoric on renegotiating NAFTA. There are five new end-of-chapter exchange rate and balance of payments real time and current data exercises. The Economics In News questions have been updated for the new article.

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* This is Chapter 26 in Economics. .

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Lecture Notes

The Exchange Rate and the Balance of Payments • • •

I.

International trade, borrowing, and lending, make it necessary to exchange currencies and the foreign exchange value of the dollar is determined in the foreign exchange market.

The exchange rates for currencies are determined by supply and demand in the foreign exchange market.

When a nation trades with other nations, the country’s balance of payments records the transactions.

The Foreign Exchange Market

Trading Currencies •

International trade, borrowing, and lending, make it necessary to exchange currencies. Foreign currency is the money of other countries regardless of whether that money is in the form of notes, coins, or bank deposits. The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another. The price at which one currency exchanges for another is called the exchange rate.

Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollars (109 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollars, stick to the “109 yen per dollar” format in your lectures. This also makes it easier for graphing and for the discussion about appreciation or depreciation. A change from 109 to 110 yen per dollar is dollar appreciation and shown by an increase along the vertical axis.

•

Over time, the U.S. dollar appreciates and depreciates against other currencies such as the Japanese yen or European euro. Currency depreciation is the fall in the value of one currency in terms of another currency. Currency appreciation is the rise in the value of one currency in terms of another currency.

• A rise in the U.S. exchange rate is called an appreciation of the dollar; a fall in the U.S. exchange rate is called a depreciation of the dollar.

The Demand for One Money is the Supply of Another Money The exchange rate is determined by demand and supply in the (competitive) foreign exchange market.

When people holding the money of some other country want to exchange it for U.S. dollars, they supply the other currency and demand dollars. When people holding U.S. dollars want to buy the currency of some other country, they supply U.S. dollars and demand the other currency.

Demand in the Foreign Exchange Market The main factors that influence the dollars that people plan to buy in the foreign exchange market are the exchange rate, world demand for U.S. exports, interest rates in the United States and other countries, and the expected future exchange rate.

•

The law of demand in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the smaller is the quantity of dollars demanded in the foreign exchange market.

There are two reasons for the law of demand: • Exports Effect: Dollars are used to buy U.S. exports. The lower the exchange rate, with everything else the same, the cheaper are U.S. exports so the greater the quantity of dollars demanded on the foreign exchange market to pay for the exports. .

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• •

Expected Profit Effect: The lower the exchange rate, with everything else the same (including the expected future exchange rate), the larger the expected profit from buying dollars so the greater the quantity of dollars demanded on the foreign exchange market.

The law of demand means that the demand curve for U.S. dollars is downward sloping, as illustrated in the figure below.

Supply in the Foreign Exchange Market The main factors that influence the dollars that people plan to sell in the foreign exchange market are the exchange rate, U.S. demand for imports, interest rates in the United States and other countries, and the expected future exchange rate.

•

•

The law of supply in the foreign exchange market is: Other things remaining the same, the higher the exchange rate, the greater is the quantity of dollars supplied in the foreign exchange market.

There are two reasons for the law of supply: • Imports Effect: Dollars are used to buy U.S. imports. The higher the exchange rate, with everything else the same, the cheaper are foreign produced imports so the greater the quantity of dollars supplied on the foreign exchange market to buy these imports.

• Expected Profit Effect: The higher the exchange rate, with everything else the same (including the expected future exchange rate), the smaller the expected profit from holding dollars so the larger the quantity of dollars supplied on the foreign exchange market.

The law of supply means that the supply curve for U.S. dollars is upward sloping, as shown in the figure.

Market Equilibrium •

Demand and supply in the foreign exchange market determine the exchange rate. In the figure, the equilibrium exchange rate is 100 yen per dollar, where the demand and supply curves intersect.

• If the exchange rate is higher than the equilibrium exchange rate, a surplus of dollars drives the exchange rate down.

• If the exchange rate is lower than the equilibrium exchange rate, a shortage of dollars drives the exchange rate up.

• The market is pulled to the equilibrium exchange rate at which there is neither a shortage nor a surplus.

Changes in the Demand for U.S. Dollars •

A change in any relevant factor other than the exchange rate changes the demand for dollars and shifts the demand curve for dollars.

• World Demand for U.S. Exports: An increase in the world demand for U.S. exports increases the demand for U.S. dollars because U.S. producers must be paid in U.S. dollars. The demand curve for U.S. dollars shifts rightward.

• U.S. Interest Rate Differential: The U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate. The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for U.S. dollars on the foreign exchange market.

An increase in the U.S. interest rate differential shifts the demand curve for U.S. dollars rightward.

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•

Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the demand for U.S. dollars increases and the demand curve shifts rightward.

Changes in the Supply of U.S. Dollars •

A change in any relevant factor other than the exchange rate changes the supply of dollars and shifts the supply curve of dollars.

• U.S. Demand for Imports: An increase in the U.S. demand for imports increases the supply of U.S. dollars because U.S. importers offer U.S. dollars in order to buy the foreign currency necessary to pay foreign producers. The supply curve of U.S. dollars shifts rightward.

• U.S. Interest Rate Differential: The larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the smaller is the supply of U.S. dollars on the foreign exchange market. An increase in the U.S. interest rate differential shifts the supply curve for U.S. dollars leftward.

• Expected Future Exchange Rate: The higher the expected future exchange rate, the greater is the expected profit from holding U.S. dollars. As a result, the supply of U.S. dollars decreases and the supply curve shifts leftward.

Emphasize that the quantity of dollars measured on the horizontal axis are only dollars that are being offered for foreign exchange, not the entire quantity of money as we learned in Chapter 8.

Changes in the Exchange Rate The exchange rate changes when the demand for and/or the supply of foreign exchange change.

•

When the expected future U.S. exchange rate increases, the demand for U.S. dollars increases and the supply decreases. As the figure shows, the demand curve shifts rightward, from D0 to D1, and the supply curve shifts leftward, from S0 to S1. The exchange rate rises, in the figure from 77 yen per dollar to 102 yen per dollar, and quantity traded does not change by much, indeed in the figure it does not change at all. Such changes took place between 2012 and 2014 when traders started to expect that the Federal Reserve would raise the interest rate in the United States while the Japanese interest rate would not change.

II. Arbitrage, Speculation, and Market Fundamentals Exchange rate expectations depend on deeper economic forces that influence the value of money.

•

Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market. Arbitrage in the foreign exchange market and international loans markets and goods markets achieves four outcomes: • The law of one price: If an item is traded in more than one place, the price will be the same in all locations. An example of this law is that the exchange rate between the U.S. dollar and the U.K. pound is the same in New York as it is in London.

• No round-trip profit: A round trip is using currency A to buy currency B, and then using B to buy A. A round trip might involve more stages, using B to buy C and then using C to buy A. Regardless, arbitrage removes the profit made from a round trip. .

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Interest rate parity: Borrowers and lenders must choose the currency in which to denominate their assets and debts. Interest rate parity, which means equal rates of return across currencies, means that for risk-free transactions, there is no gain from choosing one currency over another.

Purchasing power parity: Purchasing power parity, which means equal value of money, is the idea that, at a given exchange rate, goods and services should cost the same amount in different countries. Purchasing power parity is an important force affecting prices and exchange rates in the long run and influences exchange rate expectations.

Interest Rate Parity. Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at higher interest rates. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person (or organization) that acts as if it can beat the market.

If one U.S. dollar exchanges for 1.33 Canadian dollars, then purchasing power parity is attained when one U.S. dollar buys the same quantity goods and services in the United States as 1.33 Canadian dollars buys in Canada.

• If one U.S. dollar buys more goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually appreciate.

• Similarly, if one U.S. dollar buys less goods and services in the United States than 1.33 Canadian dollars buy in Canada, people will expect that the U.S. dollar will eventually depreciate.

The Economics in Action detail discusses the “Big Mac Index.” If you go to the website there is an interactive map and other tools that are fun to go through with students to investigate Big Mac prices throughout the world.

The Economist reports a Big Mac Index that uses the prices of McDonald’s Big Macs and purchasing power parity to make predictions about exchange rate movements. The index is somewhat tongue-in-cheek as it would be hard to arbitrage differences in Big Mac prices by taking a Big Mac on a plane from, say, Japan to the United States. However, it is easier to arbitrage the inputs into Big Macs such as beef. Thus, one might still expect some convergence of Big Mac prices over time. The Economist claims some success in its exchange rate predictions.

Speculation

Speculation is trading on the expectation of making a profit. Speculation contrasts with arbitrage, which is trading on the certainty of making a profit. Most foreign exchange transactions are based on speculation, which explains why the expected future exchange rate plays such a central role in the foreign exchange market. Changes in the expected future exchange rate instantly change the current exchange rate.

Market Fundamentals

The fundamentals underlying the exchange rate are the demand for U.S. dollars, which depends on world demand for U.S. exports, and the supply of U.S. dollars, which depends on U.S. demand for imports. Both demand and supply depend on the U.S. interest rate differential.

The Real Exchange Rate •

The nominal exchange rate is the value of the U.S. dollar expressed in units of foreign currency per U.S. dollar. It tells how many units of a foreign currency one U.S. dollar buys. The real exchange rate is the relative price of U.S-produced goods and services to foreign-produced goods .

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and services. It tells how many units of foreign GDP one unit of U.S. GDP buys. The real exchange rate, RER, is equal to

RER = (E  P)/P* •

where E is the nominal exchange rate, P is the U.S. price level, and P* is the foreign price level.

Price Levels and Money: Nominal and real exchange rates are linked by the equation RER = E  (P/P*). This relationship can be used in the short run and long run: • Short Run: In the short run, this equation determines the real exchange rate. The nominal exchange rate is determined in the foreign exchange market by the supply and demand for dollars. Price levels do not change rapidly and so any change in the nominal exchange rate translates into a change in the real exchange rate.

• Long Run: In the long run, rewrite the equation as E = RER  (P*/P). In the long run, the real exchange rate is determined by the supply and demand for imports and exports and the price level in each nation is determined by the quantity of money in that nation. So in the long run, a change in the quantity of money changes the price level and thereby changes the nominal exchange rate. This result means that in the long run, the nominal exchange rate is a monetary phenomenon. Chapter 8 showed that in the long run, the quantity of money determines a nation’s price level, so the nominal exchange rate is determined by the quantities of money in the two countries.

III. Exchange Rate Policy Because the exchange rate is the price of a country’s money, governments and central banks must have a policy toward the exchange rate. Three possible exchange rates policies are.

Flexible Exchange Rate •

A flexible exchange rate policy permits the exchange rate to be determined by demand and supply with no direct intervention by the central bank. Even so, the exchange rate is influenced by the central bank’s actions. For instance, if the Fed raises the U.S. interest rate, the U.S. interest rate differential increases, which appreciates the U.S. exchange rate. Most countries, including the United States, have flexible exchange rates.

Fixed Exchange Rate •

A fixed exchange rate policy pegs the exchange rate at a value determined by the government or the central bank and blocks the unregulated forces of supply and demand by direct intervention in the foreign exchange market. A fixed exchange rate requires direct and frequent intervention by the central bank.

• If the demand for dollars decreases or the supply of dollars increases, to fix the exchange rate the Fed buys U.S. dollars. By so doing the Fed increases the demand for dollars and raises the exchange rate. But the Fed cannot pursue this policy forever because it eventually will run out of the foreign reserves it is using to purchase the dollars.

• In the figure the demand for dollars has decreased from D0 to D1. To keep the exchange rate fixed at 100 yen per dollar, the Fed needs to buy 2 billion dollars per day, the difference between the quantity of dollars supplied at the fixed exchange rate (7 billion dollars per day) and the [new] quantity of dollars demanded (5 billion dollars per day).

To purchase these dollars the Fed must use its foreign reserves. Ultimately the Fed will run out of foreign reserves and when that takes place the Fed can no longer peg the exchange .

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rate at 100 yen per dollar.

If the demand for dollars increases or the supply of dollars decreases, with no intervention the exchange rate will rise. To fix the exchange rate the Fed sells U.S. dollars so that it increases the supply of dollars and lowers the exchange rate. But the Fed will accumulate large stocks of the foreign reserves it is accepting in payment for the dollars. The People’s Bank of China pursued such a policy to hold down the value of the yuan and while so doing accumulated billions of dollars of U.S. dollars.

Crawling Peg •

A crawling peg policy selects a target path for the exchange rate with intervention in the foreign exchange market to achieve that path. A crawling peg works like a fixed exchange rate only the target value changes. The target changes whenever the central bank changes. China is now currently using a crawling peg exchange rate policy for the yuan.

The People’s Bank of China in the Foreign Exchange Market (Economics In Action Detail) • • •

From 1997 until 2005, the People’s Bank of China fixed the Chinese exchange rate by selling yuan and buying dollars to offset the effects of increases in the demand for yuan. Between 2000 and 2014, China’s reserves increased by $3.7 trillion.

Since 2005, the People’s Bank has allowed the yuan to crawl upward. Since then the Yuan crawled slowly upward until 2014, after which it crawled slowly downward.

China most likely fixed its exchange rate to anchor its inflation rate so that it does not deviate much from the U.S. inflation rate. The Chinese inflation rate departs from the U.S. inflation rate by an amount determined by the speed of the crawl.

IV. Financing International Trade Balance of Payments Accounts •

• •

A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts: • The current account records payments for imports of goods and services from abroad, receipts for exports of goods and services sold abroad, net interest income paid abroad, and net transfers (such as foreign aid payment). The current account balance equals exports plus net interest income plus net transfers minus imports.

• The capital account records foreign investment in the United States minus U.S. investment abroad. Any statistical discrepancy is included in this account.

• The official settlements account records the change in U.S. official reserves, which are the government’s holdings of foreign currency. An increase in foreign reserves corresponds to a negative official settlements account balance. This occurs because holding foreign currency is like (but not the same as) investing abroad, which is a negative entry in the capital account.

The sum of the balances always equals zero:

current account + capital account + official settlements account = 0.

In 2016, the U.S. current account balance was negative and almost entirely offset by a positive capital account balance. Over time, the current account balance tends to mirror the capital account balance because the official settlements account balance is small.

Borrowers and Lenders Because of current account deficits and surpluses, countries, like individuals, can be borrowers or lenders.

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A country that is borrowing more from the rest of the world than it is lending to it is a net borrower. A net lender is a country that is lending more to the rest of the world than it is borrowing from the rest of the world. The United States currently is net borrower. Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation .

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that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.

The Global Loanable Funds Market Demand and Supply in Global and National Markets • •

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Demand and supply in the world global loanable funds market determines the world equilibrium real interest rate.

A country is a net foreign borrower if the world equilibrium real interest rate is less than what would be the no-trade interest rate in the country.

The figure shows this situation.

• In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 6 percent and the equilibrium quantity of loanable funds would be $1.6 trillion.

• With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this lower real interest rate, the quantity of loanable funds supplied decreases to $1.4 trillion and the quantity of loanable funds demanded increases to $1.8 trillion. The difference, $0.4 trillion, is borrowed from abroad. The country has negative net exports, with X < M. A country is a net foreign lender if the world equilibrium real interest rate exceeds what would be the no-trade interest rate in the country. The figure shows this situation.

• In the figure, when the country is isolated from international trade the equilibrium real interest rate would be 4 percent and the equilibrium quantity of loanable funds would be $1.6 trillion.

• With international trade, the real interest rate in the country becomes the world real interest rate, 5 percent. At this higher real interest rate, the quantity of loanable funds supplied increases to $1.8 trillion and the quantity of loanable funds demanded decreases to $1.4 trillion. The difference, $0.4 trillion, is loaned abroad. The country has positive net exports, with X > M. In a small country, changes in the national demand and supply of loanable funds change the country’s international loaning or borrowing and will change the country’s net exports.

Debtors and Creditors •

A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. A creditor nation is a country that during its entire history has invested more in the rest of the world than other countries have invested in it. The United States currently is debtor nation.

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The net borrower/net lender difference refers to the current flow of borrowing or lending over a period of time. The debtor nation/creditor nation refers to the stock of debt or foreign assets that exists at a moment in time.

The analogy of a country being like an individual in terms of being a borrower or lender is revealing.

However, you may want to point out a big difference in lifespan. Long periods of deficit seem bad for an individual, but are short when you are expected to live forever. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries.

The key is what the debt is being spent on. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation.

Current Account Balance and Net Exports •

The current account balance (CAB) is:

•

The main item in the current account balance is net exports (X − M). The other two items are much smaller and don’t fluctuate much.

The national accounts show that Y = C + I + G + X − M and also that Y = C + S + T. These two relationships can be equated and rearranged to give (X − M) = (S − I) + (T − G). In this formula, • (X − M) is net exports, exports of goods and services minus imports of goods and services.

• (S − I) is the private sector balance, saving minus investment.

• (T − G ) is the government sector balance, net taxes minus government expenditures on goods and services.

The formula shows that net exports equal the sum of the private sector balance and the government sector balance. There is a strong tendency for the private sector balance and the government sector balance to move in opposite directions, which means that the relationship between net exports and the other two sectors taken individually is not a strong one.

CAB = X − M + Net interest income + Net transfers •

•

Where Is the Exchange Rate?

In the short run, a change in the nominal exchange rate changes the real exchange rate and affects the U.S. current account balance. In the long run, a change in the nominal exchange rate leaves the real exchange rate unaffected and so in the long the nominal exchange rate plays no role in determining the current account balance.

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Additional Problems 1.

The Dollar’s Short-Lived Comeback The dollar fell to record lows against the euro in April. Over the next month the exchange rate rose because traders began to expect that the Federal Reserve was not going to cut U.S. interest rates any further.

CNN, May 16, 2008 Explain how expectations that the Federal Reserve will not cut the interest rate can make the dollar appreciate.

2.

Suppose that traders in the foreign exchange market come to believe that the U.S. exchange rate will rise over the next few months. How does this belief affect the demand for U.S. dollars and the supply of U.S. dollars? What is the impact of this belief on the current exchange rate? Draw a graph of the foreign exchange market to illustrate your answer.

3.

A country has a lower inflation rate than all other countries. It has more rapid economic growth. The central bank does not intervene in the foreign exchange market. What can you say (and why) about: a. The exchange rate? b. The current account balance? c. The expected exchange rate? d. The interest rate differential? e. Interest rate parity? f. Purchasing power parity?

Solutions to Additional Problems 1.

If traders come to believe that the Federal Reserve will not cut interest rates, the interest rate in the future will be higher than previously expected. With the higher future U.S. interest rate, the future U.S. interest rate differential will also be higher. In turn, the higher future U.S. interest rate differential will raise the future U.S. exchange rate. Finally, the expected higher future U.S. exchange rate increases the current demand for U.S. dollars and decreases the current supply, thereby raising the current exchange rate and appreciating the dollar.

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The rise in the expected future exchange rate increases the expected profit from holding dollars.

The increase in expected profit increases the current demand for U.S. dollars and decreases the current supply of U.S. dollars. The current exchange rate rises. Figure 9.1 shows the effect on the foreign exchange market of the change in traders’ beliefs.

The demand increases so the demand curve for dollars shifts rightward from D0 to D1. The supply curve of dollars shifts leftward from S0 to S1. The dollar immediately appreciates, rising in the figure from 110 yen per dollar to 120 yen per dollar.

a. b.

c. d. e. f.

The exchange rate most likely rises—the currency appreciates. The reason is that to preserve purchasing power parity, the lower inflation rate means that the currency must appreciate.

The current account balance depends on domestic investment relative to national saving. The balance could be positive or negative. Possibly with more rapid growth, investment in the country is high and so the current account might be in deficit.

The exchange rate will be expected to appreciate so the expected future exchange rate is higher than the current exchange rate.

The interest rate differential is negative. The interest rates in other countries exceed the domestic interest rate by an amount equal to the expected exchange rate appreciation.

Interest rate parity holds every day. If it did not, large above-average profits would be available.

Such profit opportunities do not go unexploited.

Purchasing power parity probably doesn’t hold every day, but does hold on the average in the long run.

Additional Discussion Questions 1.

In 2007−2008, the nominal exchange rate of U.S. dollars declined relative to both the Japanese yen and the European euro. What would you need to know about the U.S. economy to determine whether this would be a benefit or a problem for the U.S. economy? Point out that the United States was just starting to enter a recession in 2008, as potentially was Japan and most of Europe. The Federal Reserve was ahead of other central banks in responding to the recession by lowering the interest rate before the other central banks took action. By lowering the U.S. interest rate, the U.S. interest rate differential decreased, which decreased the demand for U.S. dollars, increased the supply of U.S. dollars, and forced the exchange rate lower. By lowering the U.S. exchange rate, U.S. exports increased, which helped keep the U.S. economy stronger than otherwise would have been the case.

2.

When the Federal Reserve Chairman Ben Bernanke repeatedly decreased the interest rate during late 2008, he was attempting to stimulate the U.S. economy by lowering the .

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interest rates in the U.S. financial markets and lowering the cost of employing productive capital. What impact did this policy have on the exchange rates in the foreign exchange markets, all else equal? The fall in U.S. interest rates means that the U.S. interest rate differential falls. The fall in the interest rate differential increases the supply of dollars to the foreign currency exchange market, shifting the supply curve of dollars rightward. It also decreases the demand for dollars, shifting the demand curve for dollars leftward. With no other changes, the equilibrium exchange rate for dollars falls. As it happened, however, other factors were not equal. In late 2008 other central banks also lowered their interest rates. And apparently investors believed that the United States had less default risk than other countries. So on net the demand for dollars actually increased and the supply decreased so that the U.S. exchange rate rose. But the increase would have been significantly greater had it not been for the actions of the Federal Reserve.

3.

In part due to the recession of 2008, the U.S. government budget changed from smaller deficits to larger deficits. What impact would this have on the net exports and private sector balances, all else equal? The three balances are related: Net exports equal the sum of government and private sector balances. If the private sector balance does not change, the net export deficit will increase. However if the public sector surplus were to increase substantially, the net export deficit might decrease.

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10

AGGREGATE SUPPLY AND AGGREGATE DEMAND**

The Big Picture Where we have been: This chapter provides the work horse model, the aggregate supply-aggregate demand model, used to explore answers to the questions about short-run macroeconomic issues.

The chapter uses the fact established in Chapter 4, that expenditure equals C + I + G + (X – M), to explain the forces that determine aggregate demand. It also draws on Chapter 3, demand and supply, for the crucial concepts of equilibrium and the distinction between shifts and movements along demand and supply curves.

Where we are going: This chapter provides a description of the AS-AD model. The treatment parallels that of the demand and supply model in Chapter 3. That is, the curves are defined and the reasons for their slopes and the factors that shift them are explained. But the curves are not formally derived. The next chapter more formally derives the aggregate demand curve from the aggregate expenditure curve. It lays out the aggregate expenditure model, explains the multiplier effect of changes in investment, describes the adjustment process that moves the economy toward the AD curve, and derives the AD curve from the AE equilibrium. Then Chapters 12, 13, and 14 make use of the aggregate supply-aggregate supply framework to explore business cycles and inflation, fiscal policy, and monetary policy.

New in the Thirteenth Edition All the data are updated through 2017 and the long-run equilibrium value in the figures is now $18 trillion to stay closer to the current U.S. economy. The Economics In The News feature has a 2017 article about stronger than expected real GDP growth in the U.S. economy. The analysis walks through the determination of potential output and explains how sustained 3 percent growth will eventually close the output gap. It is a nice application of the AD-AS model in action.

There are five new ‘news’ exercises in the back-of-chapter problems including topics of 2017 GDP, exports and imports, millennials, Fed raising the interest rate, and Brazil’s deep recession.

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* This is Chapter 27 in Economics. .

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Lecture Notes

Aggregate Supply and Aggregate Demand • •

The aggregate supply-aggregate demand (AS-AD) model explains how real GDP and the price level are determined.

The model also helps explains the factors that determine inflation and the business cycle.

Tell students that there is heated debate among economists on the most important influences in the macro economy and how to model those influences. Economists as a group are ambivalent about the aggregate supply-aggregate demand (AS-AD) model. Real business cycle theorists, who like to build their models from the base of production functions and preferences, don’t use the model because the AS and AD curves are not independent. Technological change shifts both the AS and AD curves simultaneously and in complicated ways. New Keynesian economists have dropped the model in favor of a dynamic variant that places the inflation rate on the y-axis and the output gap (real GDP minus potential GDP as a percentage of potential GDP) on the x-axis. Despite the controversy, the AS-AD model is the key macroeconomic model for most economists. The model plays a similar role in the organization of the macroeconomics to that played by the demand and supply model in microeconomics. The author does a good job of using the ASAD model to explain various schools of thought.

The AS-AD model is the best model currently available for introducing students to macroeconomics. It enables them to gain insights into the way the economy works, to organize their study of the subject, and to understand the debates surrounding the effects of policies designed to improve macroeconomic performance.

Devoting at least a week of lecture time to the AS-AD model is worthwhile. Your goal at this point in the course is to help them understand the components of the model intuitively and to put the model to work using some of its more simple and obvious features.

I.

Aggregate Supply

The quantity of real GDP supplied is the total quantity of goods and services, valued in constant dollar prices, that firms plan to produce in a given time period. This amount depends on the quantity of labor employed, the capital stock, and the state of technology. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP.

Long-Run Aggregate Supply •

•

The long-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the long run when real GDP equals potential GDP. As illustrated in the figure, the LAS curve is vertical at the level of potential GDP ($18 trillion in the figure), showing that potential GDP does not depend on the specific price level.

In the long run, the wage rate and other resource prices change in proportion to the price level. So moving along the LAS curve both the price level and the money wage rate change by the same percentage.

Short-Run Aggregate Supply •

The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other resources, and potential GDP remain constant. .

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As illustrated in the figure, the SAS curve is upward sloping. This slope reflects that a higher price level combined with a fixed money wage rate, lowers the real wage rate, thereby increasing the quantity of labor firms employ and hence increasing the real GDP firms produce.

Difference between LAS and SAS: The distinction between the LAS and the SAS comes about by assuming that resource and output prices adjust at different rates. Ask the class, “When there is an increase in demand, what do you think adjusts first, prices of goods on the shelves at Walmart or wages of employees at Walmart?” By discussing out the potential lag times in resource price adjustment, you have opened up a hotly contested item among economists. How long is that lag time? Tell the students that there are different schools of thought about this issue and during the term we will see how different assumptions yield different answers.

Movements Along the LAS and SAS Curves and Changes in Aggregate Supply Movements Along the Curves • When the price level, the money wage rate, and other resource prices change by the same percentage, real GDP remains at potential GDP and there is a movement along the LAS curve.

• When the price level changes and the money wage rate and other resource prices remain constant, real GDP departs from potential GDP and there is a movement along the SAS curve.

Shifts in the Curves • When potential GDP increases, both long-run and short-run aggregate supply increase and the LAS and SAS curves shift rightward. Potential GDP increases when the full employment quantity of labor increases, the quantity of capital increases, or technology advances.

• Short-run aggregate supply changes and the SAS curve shifts when there is a change in the money wage rate or other resource prices. A rise in the money wage rate or other resource prices decreases short-run aggregate supply and shifts the SAS curve leftward.

The flavor of the Classical-Keynesian controversy. If you want to convey the flavor of one of the biggest controversies in macroeconomics, you can do so at this early stage of the course by using only the aggregate supply curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly.

Along the SAS curve: You cannot repeat yourself too many times about this topic: Moving along the SAS curve, resource prices are fixed. Point out that this is the same assumption for the “micro” supply curve. In particular, if there is an increase in the money wage rate at the Pepsi plant, the supply curve for Pepsi shifts leftward. That same principle gets applied to all goods and services in the AS-AD model so an increase in the money wage rate shifts the SAS curve leftward.

Along the LAS curve: Students seem comfortable with the idea that the SAS curve has a positive slope but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified. Though you do not “need” to emphasize this point, what the LAS curve illustrates is that the real economy is independent of money prices!

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II. Aggregate Demand • •

The quantity of real GDP demanded is the sum of consumption expenditure (C), investment (I ), government expenditure (G), and net exports (X − M), or Y = C + I + G + (X − M).

Buying plans depend on many factors including: • The price level • Expectations • Fiscal policy and monetary policy • The world economy

The Aggregate Demand Curve •

Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. The relationship between the quantity of real GDP demanded and the price level is called aggregate demand. As the figure shows, the AD curve is downward sloping.

• The negative relationship between the price level and the quantity of real GDP demanded reflects the wealth effect (when the price level rises, real wealth decreases and so people decrease consumption) and substitution effects (first, the intertemporal substitution effect: when the price level rises, real money decreases and the interest rates rises so that consumption expenditure and investment decrease; and, second, the international price substitution effect: when the price level rises, domestic goods become more expensive relative to foreign goods so people decrease the quantity of domestic goods demanded).

Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market. This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course. At the same time that we want to simplify the aggregate demand story, we also want to avoid being misleading.

The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of aggregate demand.

A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the students don’t totally appreciate the ceteris paribus condition. We must provide intuition with stories such as the Maria stories in the textbook.

Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure. If you want to make this point when you first introduce the AD curve, you must cover the AE model in the next chapter before you cover this chapter. (The material is written in a way that permits this change of order.) If you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve. Silence is vastly better .

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than confusion. You can pull this rabbit out of the hat when you get to the next chapter if you’re covering the material in the order presented in the textbook.

Changes in Aggregate Demand •

Any factor that influences buying plans other than the price level brings a change in aggregate demand and a shift in the aggregate demand curve. Factors that change aggregate demand are: • Expectations: Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits increase aggregate demand and shift the AD curve rightward.

• Fiscal policy and monetary policy: The government’s attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services is called fiscal policy. Tax cuts or increased transfer payments increase disposable income (aggregate income minus tax payments plus transfers) and thereby increase consumption expenditure and aggregate demand. Increased government expenditures increase aggregate demand. Monetary policy consists of changes in interest rates and in the quantity of money in the economy. An increase in the quantity of money and lower interest rates increase aggregate demand.

• The world economy: Exchange rates and foreign income affect net exports (X − M) and, therefore, aggregate demand. A decrease in the exchange rate or an increase in foreign income increases aggregate demand.

III. Explaining Macroeconomic Trends and Fluctuations Short-Run and Long-Run Macroeconomic Equilibrium •

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied. This equilibrium is determined where the AD and SAS curves intersect.

• If the quantity of real GDP supplied exceeds the quantity demanded, inventories pile up so that firms will cut production and prices.

• If the quantity of real demanded exceeds the quantity supplied, inventories are depleted so that firms will increase production and prices.

Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. Describe the convergence process using the mechanism laid out in the textbook. In that process, firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output.

•

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP— equivalently, as the figure shows, when the economy is on its long-run aggregate supply curve. The figure shows the long-run macroeconomic equilibrium at a real GDP of $18 trillion and a price level of 110.

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From the short run to the long run. Explain that market forces move the money wage rate to the long-run equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage of labor, so the money wage rate rises and employment decreases. At money wage rates above the long-run equilibrium level, there is a surplus of labor, so the money wage rate falls and employment increases. At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labor and the money wage rate remains constant and employment is constant at its full employment level.

Economic Growth and Inflation • •

Economic growth occurs when potential GDP increases so that the LAS curve shifts rightward.

Inflation occurs when the AD curve continually shifts rightward at a faster rate than the LAS curve.

In the long run, only growth in the quantity of money makes the AD curve continually shift rightward.

The Business Cycle

The business cycle occurs because aggregate demand and aggregate supply fluctuate and the money wage rate does not adjust quickly enough to keep the economy at potential GDP. • A below full-employment equilibrium is a macroeconomic equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap. With a belowfull employment equilibrium, the gap is called a recessionary gap. A recessionary gap occurs when the SAS curve and the AD curve intersect to the left of the LAS curve.

• An above full-employment equilibrium is a macroeconomic equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP, the output gap, is called an inflationary gap. An inflationary gap occurs when the SAS curve and the AD curve intersect to the right of the LAS curve.

• A full-employment equilibrium is a macroeconomic equilibrium in which real GDP equals potential GDP. • The figure below to the left shows a below-full employment equilibrium with a recessionary gap of $1 trillion. The figure on the right shows an above full-employment equilibrium with an inflationary gap of $1 trillion.

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Point out to the students that to simplify analysis of the business cycle, economists typically abstract from the long-term persisting increases in the LAS curve and AD curve that generate economic growth and inflation, respectively. So, by fixing the LAS curve when considering business cycle fluctuations, economists are looking at short-term movements around a slower moving long-run equilibrium level of output. Explain to the students that one reason to abstract from these long-term movements is simply that the figures get very complicated if all the curves shift rather than just the immediately relevant ones. A second reason is the standard view that short-term movements around the LAS are driven by different economic forces than the persisting long-run shifts in the LAS curve. So abstracting from long-term growth in order to focus on business cycle fluctuations simplifies matters without any loss of relevant details.

An Economics in Action feature discusses the “World Economy Tailwinds”—more rapid real GDP growth in other countries and a depreciating dollar—that tend to increase U.S. exports and thereby reduce any remaining recessionary gap in the United States.

Fluctuations in Aggregate Demand An increase in aggregate demand shifts the AD curve rightward, as in the figure where the aggregate demand curve shifts from AD0 to AD1. In the short run, a rightward shift of the AD curve leads to movement along the SAS curve so that both the price level and real GDP increase. In the figure the economy moves from an initial equilibrium at point a with real GDP equal to potential GDP of $18 trillion and a price level of 100 to point b with real GDP of $19 trillion and a price level of 105. But in the long run, the higher price level and tight labor market lead to an increase in the money wage rate. Short-run aggregate supply decreases and the SAS curve shifts leftward, in the figure from SAS0 to SAS1. The long-run equilibrium is reached when the short-run aggregate supply has decreased enough so that the economy is back producing at potential GDP, which in the figure occurs when the economy moves from b to point c. In the long run, the increase in aggregate demand has no effect on real GDP—it has returned to potential GDP, $18 trillion in the figure--and only results in a higher price level—which has risen from 100 to 110 in the figure.

Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward.

Avoid confusing students by using “up” to correspond to a decrease in SAS. But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward.

In the figure above, instead of using identifying the short-run aggregate supply curve with SAS0 you might use SASW = $10 with the explanation that along this SAS curve the money wage rate, W, is fixed at .

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$10/hour. Then, rather than label the new short-run aggregate supply curve SAS1, can identify it as SASW = $11. You can now show your students the qualitative point that the money wage rate has increased and you can show them the quantitative point that the 10 percent increase in the price level (from 100 to 110) lead to a 10 percent increase in the money wage rate.

Fluctuations in Aggregate Supply Some business cycle fluctuations are driven by shifts in short-run aggregate supply. An increase in energy prices decreases the short-run aggregate supply and shifts the SAS curve leftward. The price level increases and real GDP decreases. The combination of recession and higher inflation is called stagflation and occurred in the United States in the 1970s as a result of the oil price shocks.

IV. Macroeconomic Schools of Thought There is a fair degree of consensus among mainstream economists about economic growth and inflation, although there is still immense debate about the business cycle. The importance of macroeconomic issues and the complexities of economic systems mean that there are strong incentives to speak knowledgeably about macroeconomics, but it is difficult for most people to evaluate whether the speaker is truly knowledgeable or a charlatan. Mainstream economic theories are completely thought out and fully articulated. Thus, one should be wary of anyone who confidently rejects that one of these mainstream theories as “just plain wrong.”

The Classical View •

• •

A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment. A new classical view is that business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change.

The uneven pace of technological advancement are the main source of business cycle fluctuations.

There is no distinct short-run aggregate supply curve because the economy is always producing at potential GDP. Classical economists emphasize that taxes blunt people’s incentives to work, so the most the government should do to affect the business cycle is to keep taxes low.

The Keynesian View • •

• •

A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required.

Aggregate demand fluctuations driven by changes in expectations (“animal spirits”) about business conditions and profits are the main source of business cycle fluctuations. Because money wages are sticky (slow to adjust), especially in the downward direction, the economy can remain mired in a recession.

A modern version of the Keynesian view known as the new Keynesian view holds that not only is the money wage rate sticky but that the prices of some goods and services are also sticky.

Keynesians believe that fiscal policy and monetary policy should be used actively to stimulate demand to end recessions and restore full employment.

Although Keynes agreed that the economy would return to its potential in the long run, he stated, “In the long run, we are all dead”. Keynes believed that because of the interaction between financial markets, the price level, and the labor market, there was no inherent tendency of the market system to return quick enough to potential GDP following an aggregate demand shock. The role of the government, in Keynes’ view, was not to replace markets with central planning, but to use stabilization policies to help the macroeconomy find equilibrium at potential GDP. Keynes’ analogy was that market capitalism in the Great .

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Depression was like a car with a broken alternator. Fiscal policy would give the economy a jump-start when aggregate demand was inadequate. Keynes worried that without active aggregate demand management, high unemployment would lead to a breakdown of capitalism, with revolution leading to totalitarianism in the form of communism or fascism.

The Monetarist View • • • •

A monetarist macroeconomist believes that the economy is self-regulating and that it will normally operate at full employment provided that monetary policy is not erratic and that the pace of money growth is kept steady.

Aggregate demand fluctuations driven by monetary policy mistakes are the main source of business cycle fluctuations.

There is a short-run aggregate supply curve because money wages are sticky.

The monetarist view of policy is that tax rates should be kept low and the quantity of money should be kept growing on a steady path. Beyond these policies, however, the government should not undertake active stabilization policy.

The Economics in the News detail discusses real GDP growth in the second quarter of 2017. This growth was more rapid than expected, which is analyzed in terms using the AD-AS model.

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Additional Problems 1.

Explain and draw a graph to illustrate how a depreciation of the dollar changes the shortrun equilibrium real GDP and price level.

2.

Suppose the government creates a fiscal stimulus by sending people checks representing temporary tax cuts. a. Explain and draw a graph to illustrate the effect of this fiscal stimulus payments on real GDP and the price level in the short run. b. At which type of short-run equilibrium would the government want to use this policy? c. Which macroeconomic school of thought would justify this policy? d. If the government used this policy when the economy was at full employment, explain what would happen in the long run. e. Draw a graph to illustrate your answer to d.

3.

What is stagflation? Explain how the increase in the price of oil can cause stagflation and draw a graph to illustrate this outcome.

Solutions to Additional Problems 1.

The depreciation of the dollar increases U.S. net exports, which increases U.S. aggregate demand. The increase in aggregate demand increases real GDP and raises the price level. These changes are illustrated in Figure 10.1. In this figure the aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, from $18.0 trillion to $18.2 trillion, and the price level rises, from 119 to 121.

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AGGREGATE SUPPLY AND AGGREGATE DEMAND

2.

a.

b.

c. d.

e.

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The fiscal stimulus check increased households’ consumer expenditure. The increase in consumption expenditure boosted aggregate demand so the aggregate demand curve shifted rightward. Figure 10.2 shows the effect of this change. The aggregate demand curve shifts rightward from AD0 to AD1. As a result real GDP increases, in the figure from $18.0 trillion to $18.1 trillion, and the price level rises, in the figure from 119 to 121.

The government wants to use this type of policy when the economy is in a below full-employment equilibrium with a recessionary gap.

Keynesian economists would support this policy.

If this stimulus policy was used when the economy was at full employment, in the short run the price rises and real GDP increases. But in the long run the money wage rate rises to reflect the higher price level. The rise in the money wage rate decreases short-run aggregate supply. Ultimately in the long run real GDP returns to potential GDP so there is no long-run change in real GDP. The price level, however, rises as short-run aggregate supply decreases. So the price level in the long-run is higher than in the short run.

Figure 10.3 shows the long-run changes described in the previous answer. After the initial shift in the aggregate demand curve from AD0 to AD1, the price level has risen. As a result the money wage rate rises so that the short-run aggregate supply curve shifts leftward, in the figure from SAS0 to SAS1. In turn the price level rises still more, in the figure ultimately to 122. Real GDP, however, decreases and eventually returns to its initial level, which is potential GDP and in the figure is $18.0 trillion.

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Stagflation is the combination of recession and inflation. Increases in the price of oil can decrease aggregate supply. The decrease in aggregate supply raises the price level—so there is inflation—and decreases real GDP—so there is a recession. Figure 10.4 illustrates these results. In this figure the aggregate supply curve shifts leftward from AS0 to AS1. As a result real GDP decreases from $18.0 trillion to $17.8 trillion and the price level rises, from 118 to 120.

Additional Discussion Questions 11. “The demand curves for all products have negative slopes. For instance, the demand curves for milk, automobiles, personal computers, and shirts all have negative slopes.

Therefore, because the aggregate demand curve shows the demand for all products, it too must have a negative slope.” Comment on this assertion. The assertion is incorrect.

Demand curves for goods and services such as milk and so forth have negative slopes because the price measured along the vertical axis is a relative price; that is, it is the price of the good or service relative to the price of another good or service. As a result, the demand curve for these goods or services captures the possibility of substitution: A higher price for a gallon of milk causes consumers to substitute away from milk and toward other beverages, such as water or soda, whose price has not risen. The price level, which is the variable along the vertical axis for the aggregate demand curve, is not a relative price. It is the average of all prices. When the price level rises, all domestic prices have risen so the only substitution possibility is toward imported goods and over time (the intertemporal substitution effect). These substitutions offer reasons why the aggregate demand curve has a negative slope. Another, possibly more important reason for the negative slope is the wealth effect: When the price level rises and nothing else changes, people’s real wealth decreases. When real wealth decreases, people’s consumption expenditure decreases so that the aggregate quantity of goods and services demanded decreases.

12. Explain why the SAS curve slopes upward and the LAS curve is vertical. The SAS curve applies in the short run; the LAS curve applies in the long run. When the price level rises, firms find that the prices of the goods and services they produce have risen. In the short run the money wage rate (and other costs) do not change. With higher prices and unchanged costs, firms find it profitable to increase their production. Hence in the short run the quantity of real GDP produced increases, which means that along the SAS curve a higher price level leads to an increase in the quantity of real GDP supplied. However in the long run money wage rates adjust to reflect the higher price level. In the long run the money wage rate and price level rise in the same proportion. In the long run, with both higher prices and .

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higher costs, firms return to their initial level of production. Hence in the long run the quantity of real GDP produced does not change, which means that along the LAS curve a higher price level leads to no change in (potential) GDP. 13. When the equilibrium real GDP is below potential GDP, how does the unemployment rate compare with the natural rate? What is the result of this state of affairs that restores the long-run equilibrium? When real GDP is less than potential GDP, the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in short-run aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate no longer falls so that all adjustments cease.

14. Explain how an increase in money wages affects the SAS curve. Why does a change in money wages affect only the SAS curve and not the LAS curve? An increase in the money wage rate means that firms’ costs have risen. At a given price level, the increase in their costs causes firms to decrease the quantity of goods and services they produce. The quantity of real GDP produced decreases and the SAS curve shifts leftward. The change in the money wage rate does not affect the quantity of production along the LAS curve because along that curve both the money wage rate and price level change in the same proportion. In other words, it is not possible to assume a given price level to investigate the effect of an increase in the money wage rate along the LAS curve because along that curve both variables change. And when both the price level and money wage rate change by the same proportion, firms will not change the quantity of real GDP they produce.

15. If the government spends more money by buying more goods and services, is this change an example of fiscal policy or monetary policy? When the government increases its expenditure by purchasing more goods and services, the government is engaging in fiscal policy.

16. What is a recessionary gap? How does the economy adjust to eliminate a recessionary gap? A recessionary gap occurs when actual real GDP is less than potential GDP. With a recessionary gap the unemployment rate exceeds the natural rate. In the labor market, the high unemployment rate forces the money wage rate lower. As the money wage rate falls, firms hire more workers and short-run aggregate supply increases. The increase in shortrun aggregate supply increases real GDP. Eventually the money wage rate falls sufficiently so that real GDP equals potential GDP. At this point, long-run equilibrium is reached and the money wage rate stops falling so that short-run aggregate supply stops increasing.

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C h a p t e r

11

EXPENDITURE MULTIPLIERS**

The Big Picture Where we have been: Chapter 11 uses the background provided in Chapters 4 and 10 to focus on aggregate expenditure and aggregate demand. It builds on the division of GDP into C + I + G + (X – M) explained in Chapter 4 and then derives the aggregate demand curve previously used in Chapter 10.

Where we are going: Chapter 11 examines the details of the AS-AD model by focusing on the factors that determine the AD curve. The AD curve is important in all the core short-run macroeconomic chapters. The material in this chapter is used in Chapters 12-14 on the business cycle, fiscal policy, and monetary policy.

New in the Thirteenth Edition The data in this chapter have been updated to reflect 2017 information. The content of this chapter is substantially the same as the 12th edition. As was done in the previous chapter, the long run equilibrium level of real GDP is $18 trillion. The Economics In The News feature reports the BEA statistics for 2017 with economic analysis using the Aggregate Expenditure model. Inventories along with other key macroeconomic variables are discussed. The end-ofchapter “news” problems include recent topics of household wealth effects, inventories, stimulus in Korea, stimulus in Japan, and U.S. consumer sentiment.

*

* This is Chapter 28 in Economics. .

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Lecture Notes

Expenditure Multipliers • • •

The Keynesian model focuses on the short run.

In the Keynesian model, business cycle fluctuations are driven by changes in the components of aggregate expenditure, especially investment.

The multiplier effect describes the amplified effect on real GDP from changes in expenditure.

Historical background. If you want to talk about Keynes and his contribution to economics, this is probably the best place to do it.

The model, now generally called the aggregate expenditure model, presented in this section is the essence of Keynes General Theory. According to Don Patinkin, a leading historian of economic thought and Keynes scholar, the innovation of the General Theory was to replace price with income (GDP) as the equilibrating variable. This version of the model cannot be found in the General Theory, mainly because Keynes was writing before the national income accounting system had been developed. So he made up his own aggregates, based on employment and a money wage measure of the price level. But the words and equations of the General Theory can be translated readily into the textbook version of the model. This version of the model first appeared in The Elements of Economics, a textbook authored by Lorie Tarshis published in 1947. It was popularized by Paul Samuelson in the first edition of his celebrated text published in 1948.

The main difference between the Keynesian cross model of the 1940s and the aggregate expenditure model of today is that from the 1940s through the mid-1960s, economists believed that the fixed price level assumption was an acceptable (if not exactly accurate) description of reality, so the model was seen as actually determining real GDP, and the multiplier was seen as an empirically relevant phenomenon. In contrast, today, we see the model as part of the aggregate demand story. The value of the model today— and it is valuable today and not, as some people claim, eclipsed by the AS-AD model and irrelevant—is that it explains the multiplier that translates a change in autonomous expenditure into a shift of the AD curve and it explains the multiplier convergence process that pulls the economy toward the AD curve. (When an unintended change in inventories occurs, the economy is off the AD curve but moving toward it.)

I.

Fixed Prices and Expenditure Plans

The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services. As a result, the price level is fixed and so aggregate demand determines real GDP.

Expenditure Plans • •

Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports.

In the very short term, planned investment, planned government expenditure, and planned exports are fixed. Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income. An increase in real GDP increases aggregate expenditure and an increase in aggregate expenditure increases real GDP.

Consumption Function and Saving Function •

Consumption expenditure and saving depend on the real interest rate, disposable income, wealth, and expected future income. Disposable income is aggregate income minus taxes plus transfer payments. The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. The relationship between saving and disposable income, other things remaining the same, is called the saving function.

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•

•

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The figure shows a consumption function. Along the 45 degree line, consumption equals disposable income. When the consumption function is above the 45 degree line, there is dissaving. When the consumption function is below the 45 degree line, there is saving.

The consumption expenditure when disposable income is zero, $4 trillion in the figure, is autonomous consumption. Consumption expenditure in excess of this amount is induced consumption.

The 45° line. Don’t assume that your students immediately understand the 45° line! Spend a bit of time explaining how to “read” it. Fundamentally, it shows all points where x = y. This line happens to be a 45° line when the scales along the x-axis and the y- axis are the same. Then point out that the horizontal distance to a point along the x-axis equals the vertical distance from that point to the 45° line. So at all points along the 45° line, x = y. If you wish, you can go on to show the students how the x = y line changes its appearance if we stretch or squeeze the scale on the y-axis holding the scale on the x-axis constant.

Emphasize that x and y can be anything. In the figure above, x is disposable income and y is consumption expenditure; in the figure below, x is real GDP and y is aggregate planned expenditure.

Marginal Propensities to Consume and Save • • •

The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, C/YD. The MPC is the slope of the consumption function, which is 0.67 in the figure.

The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, S/YD. The MPS is the slope of the saving function.

The sum of the MPC plus the MPS equals 1.0.

Marginal propensities. The text defines the MPC and MPS, and shows that they sum to one because disposable income can only be consumed or saved. Students generally relate to percentages better, so you can explain it as percent but stress that we use the decimal number for analytical purposes.

Other Influences on Consumption Expenditure and Saving A change in any other factor influencing consumption and saving besides disposable income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function. An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward.

•

The U.S. MPC is about 0.9. Since the 1960s, increases in expected future income and wealth have shifted the consumption function upward.

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Consumption as a Function of Real GDP and the Import Function • •

For a given level of taxes and transfers, disposable income changes when real GDP changes, so consumption also is a function of real GDP. We use this observation when we derive the aggregate expenditure function.

Just as consumption of domestically produced goods and services depends on real GDP, so do imports. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports.

II. Real GDP with a Fixed Price Level Real GDP (Y)

Consumption expenditure (C)

Investment (I)

Government expenditure (G)

Exports (X)

Imports (M)

Aggregate planned expenditure (AE=C+I+G+X−M)

(trillions of 2009 dollars) 16.0

12.2

2.0

2.0

1.0

0.8

16.4

17.0

13.1

2.0

2.0

1.0

0.9

17.2

18.0

14.0

2.0

2.0

1.0

1.0

18.0

19.0

14.9

2.0

2.0

1.0

1.1

19.8

Aggregate Planned Expenditure and Real GDP •

•

•

Aggregate planned expenditure, AE, is the sum of planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports. The above table shows the calculation of an aggregate planned expenditure schedule. The figure shows the resulting AE curve.

Consumption expenditure minus imports vary with real GDP and are induced expenditure. The sum of investment, government expenditures, and exports do not vary with real GDP and are autonomous expenditure. Consumption expenditure and imports also have an autonomous component.

Actual expenditure can differ from planned expenditure because firms do not always sell what they plan to, in which case they have unplanned inventory investment. For instance, a car that is manufactured but not immediately sold is part of that firm’s actual inventory investment regardless of whether the firm planned to add it to inventory or not.

Equilibrium Expenditure and Convergence to the Equilibrium • •

Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. In the figure, equilibrium expenditure is $18 trillion.

If aggregate expenditure does not equal its equilibrium, forces lead to convergence. For example, if real GDP exceeds aggregate planned expenditure, firms find their inventories are increasing more than planned. The unplanned inventory accumulation leads firms to cut production so that real GDP decreases, which decreases aggregate planned expenditures. Real GDP still exceeds aggregate planned expenditure, but by less than before. The process continues until real GDP equals aggregate planned expenditure so that there is no unplanned inventory accumulation.

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III. The Multiplier • •

•

The multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to determine the change in equilibrium expenditure and real GDP. When there is an autonomous change in a component of expenditure such as investment, additional changes in aggregate expenditure are set in motion. Because of the feedback between real GDP and consumption expenditure, the total change in real GDP is larger than the initial change in autonomous expenditure.

The multiplier effect operates for a decrease as well as an increase in autonomous expenditure.

Work through an example of a change in government spending. Suppose there are no taxes, no imports, no exports and the MPC is 0.9. If the government purchases $5 billion of weapons from Nuc’s-R-US, what happens to that spending? Nuc’s has to pay all of its employees, subcontractors and material suppliers among other costs. These costs to Nuc’s turn into income (Y) for others (remind your students of the circular flow). These other people are going to consume 90 percent of that income, $45 billion, at stores such as JCPenney. Now JCPenney must pay its costs, which again turns into other people’s income, of which 90 percent again gets spent again ($40.5 billion) and so on and so on and so on…

Explain to the students that we have a short-cut to explain this iterative process and capture the total change in income (Y) from the change in government spending (G). That short-cut is the multiplier, which shows that the change in GDP is given by GDP = 1/(1 − MPC) × G

Why is the Multiplier Greater Than 1?

An increase in autonomous expenditure increases real GDP and the increase in real GDP induces an additional increase in aggregate expenditure (primarily an increase in consumption expenditure). Each additional increase in aggregate expenditure increases real GDP further, leading to yet further increases in aggregate expenditure. The process converges because the increase in aggregate expenditure is smaller at each step of the process.

The Multiplier and the Marginal Propensities to Consume and Save •

•

•

The change in real GDP can be divided into the change in induced expenditure plus the change in autonomous expenditure, Y = N + A, where Y is real GDP, N is induced expenditures, and A is autonomous expenditure. The slope of the AE curve = N÷Y, so N = (slope of AE curve) Y. Using this equality in the previous formula shows Y = (slope of AE curve) Y + A. Solving for 1 the change in GDP, Y, gives Y =  A. This last result shows that the 1 − slope of the AE curve 1 multiplier equals . In the previous figure, the slope of the AE curve is 0.8, so 1 − slope of the AE curve the multiplier is 5.0.

If there are no imports or income taxes, the slope of AE curve equals the MPC so the multiplier 1 1 equals or, equivalently, .

1 − MPC MPS The size of the multiplier depends on the MPC and the MPS. The smaller the MPC or, equivalently, the larger the MPS, the smaller the increase in expenditure at each step of the multiplier process and so the smaller the multiplier.

The basic idea and practice. Students need quite a lot of practice using multipliers. One good problem involves working out the effects on consumption as well as on GDP of a change in investment (when the price level is fixed). The best way to present this problem to the students seems to be sequentially. Begin by giving them the data necessary to deduce how real GDP changes from an increase in investment. Tell them there is no foreign trade, so that there are no exports or imports, and no income taxes. Tell them that the marginal propensity to consume is b (pick any valid number you like), and that investment has .

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changed by I (pick any valid number you like). Then, after the students have computed the change in GDP, ask them what the change in consumption expenditure is.

Review their attempts to answer this question as follows: The change in GDP, Y, is given by the equation: Y = C + I. Given I from the initial statement of the problem and Y from the first set of calculations, the students can readily calculate C. Focusing the students’ attention on the change in consumption is important because it reinforces the point that a change in autonomous expenditure (investment in this example) leads to an induced change in consumption expenditure and that this increase in consumption expenditure is the source of the multiplier.

An Economics in Action detail analyzes the multiplier in the Great Depression. The analysis concludes that the multiplier during that episode in history equaled 1.6.

The Effect of Imports and Income Taxes on the Multiplier; Business Cycle Turning Points • • •

Imports and income taxes both mean that the increase in expenditure on domestic production will be smaller at each step of the multiplier process and so the multiplier is smaller.

An unexpected decrease in autonomous expenditure is signaled by a buildup of unplanned inventories. The buildup in inventories sets the multiplier process in motion that decreases aggregate expenditure and real GDP so that a recession follows.

An unexpected increase in autonomous expenditure is signaled by an unwanted depletion of inventories. The depletion in inventories sets the multiplier process in motion and an expansion follows.

The idea that prices are fixed, even in the very short run, is controversial in economics. However, the fact that changes in inventories have long been a good leading indicator of business cycles is less controversial.

IV. The Multiplier and the Price Level In the short run, when firms find their inventories changing in an unexpected fashion, they change their production not their prices. But eventually they also change prices. To study the determination of the price level and real GDP the AS-AD model must be used. The AD curve is related to the AE curve.

The Aggregate Expenditure Curve and the Aggregate Demand Curve •

•

The AE curve is the relationship between aggregate planned expenditures and real GDP, all other influences (such as the price level) remaining the same. The AD curve is the relationship between the aggregate quantity of goods and services demanded and the price level. When the price level changes, the AE curve shifts and there is a movement along the AD curve.

A change in the price level has two effects on consumption expenditure: • Wealth Effect: A rise in the price level decreases the purchasing power of consumers’ real wealth, which decreases their consumption expenditures.

• Substitution Effects: A rise in the price level makes purchasing today more expensive relative to the future (an intertemporal substitution effect). It also makes U.S. goods and services more expensive relative to imports (an international substitution effect).

The multiplier and the price level: Emphasize the key point of this section: That the AE model and the multiplier tell us how far the AD curve shifts when autonomous expenditure changes. It is through the multiplier process that expenditure and GDP respond to unplanned changes in inventories. I like to draw out the model with AE curve on top and the AD and AS curves on the bottom. Then: 1. Shift AE curve upward by change in G. 2. Show the larger change in Y due to multiplier.

3. Shift the AD curve rightward by an amount equal to the change in Y holding the price level constant. .

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Ask the students, “Will the economy get the full change in Y?” They will see that in that the upward sloping SAS curve means that there is an increase in the price level, lowering the multiplier effect.

4. Next, show them the price level effect in the AE graph (a smaller downward shift in the AE curve).

Now ask them, “How big is the multiplier in the long run?” You should be able to get a few to mumble “Zero”.

So, tell them the conclusion: There is no multiplier in the long run! If the long run is not so long, then it is questionable to increase G in order to increase Y. Students appreciate learning about the tension in economics surrounding this issue since it relates well with politics too.

The mechanics of the relationship between the AE and AD curves. Students need a lot of help and clear explanation of the mechanics of the link between these two curves. Here’s what to stress: 1. The AE curve shows how aggregate planned expenditure depends on real GDP (through the effects of disposable income), other things remaining the same.

2. The AD curve shows how equilibrium aggregate expenditure depends on the price level, other things remaining the same.

The next two points are really hard for students: 3. A change in the price level changes autonomous expenditure, which shifts the AE curve, generates a new level of equilibrium expenditure, and creates a new point on the AD curve.

4. A change in autonomous expenditure at a given price level shifts the AE curve, generates a new level of equilibrium expenditure, and shifts the AD curve by an amount equal to the change in autonomous expenditure multiplied by the multiplier.

•

•

The wealth effect and the substitution effects show that a rise in the price level decreases consumption expenditure. So, as shown in the figure below to the left, a rise in the price level from 120 to 140 decreases aggregate planned expenditure and shifts the AE curve downward from AE0 to AE1. In the figure, equilibrium expenditure decreases to $14 trillion.

The diagram to the right, below, shows that when the price level rises from 120 to 140, there is a movement along the AD curve from point a to point b. The aggregate quantity of real GDP demanded decreases from $18 trillion (which is the initial equilibrium expenditure in the AE diagram to the left) to $16 trillion (which is the new equilibrium expenditure along AE1 in the AE diagram to the left).

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•

If the AE curve shifts for any reason other than a change in the price level, then the AD curve also shifts. For instance, an increase in autonomous expenditures shifts the AE curve upward and increases equilibrium expenditure by a multiplied amount. In this case, the AD curve shifts rightward and the amount of the rightward shift is equal to the increase in equilibrium expenditure.

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In the figure to the right, autonomous expenditure increases so that the AD curve shifts rightward. The multiplied increase in autonomous expenditure has created a $2 trillion increase in equilibrium expenditure, so the AD curve shifts rightward by $2 trillion (which equals the length of the double headed arrow) from AD0 to AD1.

Equilibrium Real GDP and the Price Level • •

•

Aggregate demand and short-run aggregate supply determine the equilibrium price level and real GDP. In the short run: • An increase in aggregate demand raises the price level and increases real GDP. In the figure to the right, the increase in aggregate demand and rightward shift of the aggregate demand curve from AD0 to AD1 creates a movement from point a to point b so that the price level rises from 120 to 130 and real GDP increases from $18 trillion to $19 trillion.

• The increase in real GDP ($1 trillion) is less than the initial increase in equilibrium expenditure ($2 trillion) because the rise in the price level decreases aggregate planned expenditure. In terms of the AE curve, the increase in the price level shifts the AE curve downward.

• Because the actual increase in real GDP is less than the initial increase in equilibrium expenditure, the multiplier is smaller once price level effects are taken into account. The more that the price level changes (that is, the steeper the SAS curve), the smaller the multiplier in the short run.

In the long run: • Real GDP exceeds potential GDP and employment exceeds full employment. So the money wage rate rises, which decreases the short-run aggregate supply and shifts the SAS curve leftward. The economy moves along the AD curve so that the price level rises and real GDP decreases.

• In the figure above, the economy moves along AD1 from point b to point c. (The shift in the SAS curve is not illustrated in order to simplify the figure.) The price level rises from 130 to 140 and real GDP decreases from $19 trillion back to potential GDP of $18 trillion.

• The further increase in the price level further decreases aggregate planned expenditure. In terms of the AE curve, the AE curve shifts downward and eventually returns to its initial level.

As a result, the long-run multiplier is equal to zero.

It is important to emphasize that the aggregate expenditure model is not without connection to the AS-AD model. Point out to the students that the AE model provides the underpinnings for the AD curve in the ASAD model used throughout macroeconomics. That is, the students can now understand why the AD curve shifts, why it is downward sloping, and why changes in the price level lead to movements along the AD curve.

It may be a good time to remind students that, just as the Keynesian AE model provides underpinnings for the AD curve, the labor market/aggregate production function model discussed in Chapter 6 provides underpinnings for the long-run aggregate supply curve. Thus, the mechanics of the model have not changed, but the students now have a deeper understanding of the forces behind those mechanics.

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The Economics in the News section studies expenditure changes in the 2017 expansion. It analyzes the growth during the second quarter in terms of the aggregate expenditure model. It focuses on which changes in autonomous expenditure were responsible for increasing aggregate expenditure and hence real GDP.

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Additional Problems 1. a. How is it possible for households to have a negative savings rate? What has caused this negative household savings rate? b. Is this negative household savings rate sustainable in the long-run?

2.

Why is the multiplier only a short-run influence on GDP?

3.

When the economy is in a recession and the government enacts a stimulus package, why might a low MPS be good in the short-run in this situation, but not in the long-run?

Solutions to Additional Problems 1.

a.

b.

Households can have a negative saving rate by borrowing. Households increase their borrowing if their wealth rises, if the real interest rate falls, or if their expected future income rises. Any or all of these factors could lead to a negative saving rate.

A negative saving rate is not sustainable in the long run. In the long run the saving rate must be positive, if for no other reason than to repay the borrowing.

2.

The multiplier has only a short-run influence on real GDP because in the long run the money wage rate changes. The change in the money wage rate affects short-run aggregate supply and lowers the price level. The fall in the price level restores aggregate planned expenditure back to its initial level and moves the economy back to its long-run equilibrium. The long-run change in aggregate expenditure offsets the initial multiplier effect on real GDP.

3.

In the short run, the fear is that a stimulus package while not have enough force to move the economy back to potential GDP. In this situation a small MPS is desirable because it means more spending from any increase in disposable income. However in the long run the economy needs saving to help it grow. Saving in the United States is quite low so in the long run a small value for the MPS is not helpful.

Additional Discussion Questions 11. Why is there a “two-way” link between consumption and GDP? Consumption is part of aggregate expenditure so an increase in consumption increases aggregate expenditure and hence increases GDP. Simultaneously GDP is equal to aggregate income so an increase in GDP increases disposable income and hence increases consumption.

12. How does an increase in disposable income affect the consumption function? An increase in expected future income? An increase in disposable income leads to a movement upward along the consumption function. An increase in expected future income shifts the consumption function upward.

13. If the consumption function shifts upward, what happens to the saving function? Why? If the consumption function shifts upward, the saving function shifts downward. The upward shift in the consumption function means that for each level of disposable income consumption increases. If consumption increases at each level of disposable income, saving necessarily must decrease. The decrease in saving at each level of disposable income means that the saving function shifts downward.

14. When is actual aggregate expenditure different from planned aggregate expenditure?

What happens to bring the two back to equality? Actual aggregate expenditure differs from planned aggregate expenditure whenever the economy is not at its equilibrium. These .

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amounts differ as a result of unplanned inventory changes. Take, for instance, the situation when actual aggregate expenditure exceeds equilibrium expenditure. In this case the 45° line, which shows actual aggregate expenditure, lies above the aggregate planned expenditure curve, which shows planned aggregate expenditure. Hence actual aggregate expenditure exceeds planned aggregate expenditure. In this situation actual inventory change—which is the measure of inventory change that is included in actual aggregate expenditure—exceeds planned inventory change—which is the measure of inventory change that is included in planned aggregate expenditure. Because actual inventory change exceeds the planned inventory change, firms are finding that their inventories are accumulating in an undesired fashion. They respond to this state of affairs by decreasing their production. As production decreases, real GDP and hence aggregate expenditure decrease until aggregate expenditure eventually equals equilibrium expenditure.

15. Explain why income taxes reduce the size of the expenditure multiplier. The expenditure multiplier results because an increase in autonomous expenditure increases disposable income and induces additional consumption expenditure. In turn the additional consumption expenditure increases disposable income once again, which then induces still additional consumption expenditure. The result that expenditure increases because of the initial increase in autonomous expenditure and then also because of the induced increase in consumption expenditure is why the expenditure multiplier exists. Income taxes decrease the size of the increase in disposable income that results from an increase in expenditure.

Therefore the resulting (induced) increase in consumption expenditure is smaller so that the overall expenditure multiplier is smaller.

16. Explain the difference between the aggregate expenditure curve and the aggregate demand curve. The aggregate expenditure curve shows how aggregate expenditure changes when GDP changes. The aggregate demand curve shows how (equilibrium) expenditure and GDP change when the price level changes.

17. Suppose that exports (autonomously) increase. What happens to the aggregate expenditure curve? The equilibrium level of aggregate expenditure? The aggregate demand curve? The aggregate expenditure curve shifts upward. Through the multiplier process the equilibrium level of aggregate expenditure increases. The aggregate demand curve shifts rightward by an amount equal to the increase in equilibrium expenditure.

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THE BUSINESS CYCLE, INFLATION AND DEFLATION**

The Big Picture Where we have been: Chapter 12 uses the AS-AD model developed in Chapter 10 to explore business cycles, inflation, and deflation. The distinction between the short-run and long-run aggregate supply curves is useful for appreciating the difference between the short-run and long-run Phillips curves. Chapter 12 also draws on the definition of inflation in Chapter 5.

Where we are going: Chapter 12 is the last of three chapters dealing with macroeconomic fluctuations. The explanation of the business cycle through the lens of the aggregate supply-aggregate demand model lays the foundation for the next two chapters, on fiscal policy and monetary policy respectively.

New in the Thirteenth Edition The content of the chapter is substantially the same as the previous edition except that the data have all been updated through 2017. As in the prior chapters, the equilibrium level of real GDP is now $18 trillion to reflect better the level in the U.S. economy. The Economics In The News has an article that discusses the drop in the unemployment rate in the Eurozone and other relevant economic factors there. Six new end-of-chapter current event exercises are added which include topics of U.S. inflation, the inflation puzzle, wages and technology, Europe deflation, the Phillips curve, and the U.K. slowdown.

*

* This is Chapter 29 in Economics. .

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Lecture Notes

The Business Cycle, Inflation and Deflation • • • •

I.

Explain how aggregate demand shocks and aggregate supply shocks create the business cycle Explain how demand-pull and cost-push forces bring cycles in inflation and output Explain the causes and consequences of deflation Explain the short-run and long-run tradeoff between inflation and unemployment

The Business Cycle

Business Cycles. Most principles of economics textbooks have a chapter that is similar to this one.

However, many of them contain an extended discussion to the effect that, “This school of thought thinks this, but this other school of thought disagrees, and, by the way, here’s a third school of thought that thinks the first school is partially correct but partially wrong ...” This material is (appropriately enough!) found to be exceptionally tedious by the students. Fortunately, Parkin’s chapter is not at all like these other weak attempts. Parkin shows the students how the schools relate to each other and presents an incredibly exciting chapter.

You can take advantage of this fact in your lecture by discussing with your students which school of thought best describes your views and what evidence convinced you. Just as students are always fascinated by why their instructor chose his or her field, so, too, are students fascinated about where their instructor fits into the scheme of controversies that they are learning about. By discussing your place in the line-up of different schools, be it “hard-line” monetarist, or new Keynesian, or an eclectic mixture, you can be guaranteed of your students’ strong interest when you discuss this topic.

You might also point out to the students that theories are not necessarily mutually exclusive. For instance, even though you may be, perhaps, a monetarist, this does not necessarily mean that you totally deny that the factors emphasized by real business cycle proponents are occasionally important. By identifying your point of view and also giving the students some instruction about your view as to the usefulness of the other approaches, you can not only interest them but also help give them an enhanced general understanding of macroeconomics.

Mainstream Business Cycle Theory The mainstream business cycle theory regardless fluctuations in aggregate demand around a growing potential GDP (and hence constantly rightward shifting LAS and SAS curves) as the cause of the business cycle. Real GDP differs from potential GDP when money wage rates do not offset changes in the price level.

• •

•

•

Keynesian Cycle Theory: The Keynesian cycle theory asserts that fluctuations in investment driven by fluctuations in business confidence—summarized by the phrase “animal spirits”—are the main source of fluctuations in aggregate demand. Money wage rates are assumed rigid.

Monetarist Cycle Theory: The monetarist cycle theory asserts that fluctuations in both investment and consumption expenditure, driven by fluctuations in the growth rate of the quantity of money, are the main sources of fluctuations in aggregate demand. Money wage rates are assumed rigid.

New Classical Cycle Theory: The new classical cycle theory asserts that the money wage rate and hence the position of the SAS curve are determined by the rational expectation of the price level, which depends on potential GDP and expected aggregate demand. Because the money wage rate changes with expected changes in aggregate demand, only unexpected fluctuations in aggregate demand lead to business cycle fluctuations.

New Keynesian Cycle Theory: The new Keynesian cycle theory asserts that today’s money wage rates were negotiated at many past dates, which mean that past rational expectations of the current price level influence the money wage rate and the position of the SAS curve. Because the .

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money wage rate does not change with newly expected changes in aggregate demand, both expected and unexpected fluctuations in aggregate demand lead to business cycle fluctuations.

Real Business Cycle Theory The real business cycle theory (or RBC theory) regards random fluctuations in productivity as the main source of economic fluctuations.

• •

•

RBC Impulse: changes in the growth rate of productivity that results from technological change. A decrease in productivity growth brings a recession and an increase brings an expansion.

Productivity shocks are measured using growth accounting The RBC Mechanism: A change in productivity changes investment demand and the demand for labor.

• If productivity falls, investment demand and hence the demand for loanabe fund decreases. In addition, the demand for labor decreases. The decrease in the demand for loanable funds means the real interest rate falls. According to RBC theory, the fall in the real interest rate decreases the supply of labor because of intertemporal substitution. Because both the supply of labor and the demand for labor decrease, employment decreases and the change in the real wage rate is small. Real GDP decreases.

Money plays no role in generating business cycles in the RBC theory; it affects only the price level.

I like to motivate RBC theory by suggesting that economists, such as Lucas and Prescott, challenged our previous portrayal of the LAS curve as being a stable curve that the short run fluctuations revolve around.

You can use your arm to suggest that the LAS curve itself might shift leftward and rightward because of technology continuously impacting productivity in unstable ways.

Criticisms and Defenses of Real Business Cycle Theory •

•

Critics assert that money wages are sticky and that intertemporal substitution is too weak to account for large fluctuations in the supply of labor, which are necessary for RBC theory to explain the empirical fact that there are large fluctuations in employment with only small fluctuations in the real wage rate.

A second criticism of RBC theory has to do with the direction of causality between productivity and business cycle fluctuations. RBC theory assumes changes in productivity cause business cycle fluctuations. Traditional aggregate demand theories suggest that measures of productivity change as a result of business cycle fluctuations. For instance, they assert that in expansions, capital and labor are used more intensely so that measured productivity increases, even with no change in technology.

What does it mean to use capital and labor more intensely? It is easy to see with labor hours. A firm could record the same number of labor hours in an expansion as in a recession. But, if the firm is trying to increase production to meet high demand in the expansion, workers will work harder and, therefore, be more productive in the expansion. This change in productivity is not related to technology but growth accounting likely will (erroneously) attribute the increase in productivity to a technological advance.

•

RBC theory defenders point out that the theory is consistent with microeconomic evidence about labor supply decisions and labor demand and investment demand decisions.

II. Inflation Cycles Inflation is a process in which the price level is rising and money is losing value. Inflation is not a rise in one price—it is a broad increase in the price level. Inflation also is not a one-time jump in the price level. It is an ongoing process.

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There are many examples of one-time jumps in the price level that are not the same as inflation. In Canada, when the federal sales tax was changed in the early 1990s, there was a one-time increase in the CPI. Likewise, when the euro was introduced in 2001, there were one-time increases in many prices in some countries. Neither of these events led to a persistent rise in the rate at which the price level increased and measured inflation using the CPI fell to previous levels soon after the one-time events.

Demand-Pull Inflation An inflation that results from an initial increase in aggregate demand is called demand-pull inflation. Any factor that increases aggregate demand, such as an increase in the quantity of money, an increase in government expenditure, or an increase in exports, can start a demand-pull inflation.

•

•

•

In the short run, an increase in aggregate demand raises the price level and increases real GDP. In the figure the aggregate demand curve shifts from AD0 to AD1 so that the economy moves from point a to point b and the price level rises from 100 to 110.

Real GDP exceeds potential GDP and so in the tight labor market the money wage rate rises. The rise in the money wage rate decreases short-run aggregate supply. In the figure, the SAS curve shifts from SAS0 to SAS1. As a result, the economy moves from point b to point c and the price level rises even more, in the figure to 120. Real GDP returns to potential GDP. Inflation occurs only if aggregate demand continues to increase. And aggregate demand continues to increase only if the quantity of money persistently increases.

Demand-Pull Inflation. The potential difficulty with both demand-pull and cost-push inflation stories is how the one-time increase translates into an inflationary process. It is relatively easy to come up with stories as to why aggregate demand might shift to the right, for example because of persistent government budget deficits. (However immediately tell the students that if the budget deficit does not constantly increase in size relative to GDP, it will not lead to a constant increase in aggregate demand.) What is a little harder is to provide a plausible story as to why the monetary authorities would continue to accommodate the budget deficit with continuous increases in the quantity of money. Point out that this has been rare in the United States, and has tended to happen when the political situation was such that the Fed was not willing to be blamed for an increase in unemployment. In other countries, particularly where the central bank is less independent than in the United States, it has been more common for the central bank to consistently monetize budget deficits.

Cost-Push Inflation An inflation that results from an initial increase in costs is called cost-push inflation. The two main sources of increases in costs are an increase in money wage rates or an increase in the money prices of raw materials.

•

The cost hike decreases short-run aggregate supply, which raises the price level and decreases real GDP. In the figure the shortrun aggregate supply curve shifts from SAS0 to SAS1 so that the economy moves from point a to point b and the price level rises .

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from 100 to 110. The combination of a rise in the price level and a fall in real GDP is called stagflation.

One possible response to the decrease in real GDP is for the Fed to use monetary policy to increase aggregate demand. If the Fed increases aggregate demand, real GDP increases and the price level rises still higher. In the figure, this Fed policy shifts the aggregate demand curve from AD0 to AD1 and the price level rises to 120.

Inflation occurs only if, in response to the higher price level, the force that initially decreased aggregate supply recurs so that aggregate supply continues to decrease and, at the same time, the Fed continues to increase aggregate demand.

Cost-Push Inflation. The text gives a good description of the first oil price increase in the 1970s as a costpush inflation, and contrasts it well with the Fed’s refusal to accommodate the second oil price increase in 1979. An explanation of how cost-push can be a more widespread cause of inflation in other countries can be given in terms of countries where labor is highly unionized, and in effect there are attempts by different interest groups to obtain shares of GDP that add up to more than 100 percent, with accommodation by a weak monetary authority. Such a process of repeated wage increases, inflation, and monetary accommodation can give rise to continuing inflation. Analysts often “explain” the cause of inflation by focusing attention on the good or service whose price increased the most during the most recent time period. This is incorrect; inflation is the result of monetary growth. To explain inflation, economists are looking for an explanation that fits all cases not an explanation that focuses on specific prices of specific goods that differ from one inflation to another.

Expected Inflation •

•

•

When inflation is anticipated, the money wage rate changes to keep up with the anticipated inflation. So when the AD curve shifts rightward, increasing the price level, the money wage rate increases and the SAS curve shifts leftward. If the increase in the price level is fully anticipated, then the money wage rate rises by the same percentage so that the real wage rate remains constant. There are no deviations from full employment. The magnitude of the shift in A D equals that in SAS so that GDP remains equal to potential GDP and the economy moves up along the LAS curve, from point a to point c in the figures above.

If inflation is not perfectly anticipated, the money wage rate changes but by a different percentage than the price level. Some of the inflation is unanticipated, so as a result the real wage rate changes and there are deviations from full employment. If aggregate demand grows faster than anticipated, real GDP exceeds potential GDP and the economy behaves as if it were in a demand-pull inflation. If aggregate demand grows slower than anticipated, real GDP is less than potential GDP and the economy behaves as if it were in a cost-push inflation.

Because of the costs of unanticipated inflation, there are benefits to forming accurate forecasts of inflation. The best available forecast is the one that is based on all relevant information and is called a rational expectation.

III. Deflation An economy experiences deflation when it has a persistently falling price level.

What Causes Deflation?

•

The starting point for understanding the cause of deflation is to distinguish between a one-time fall in the price level and a persistently falling price level. A onetime fall in the price level is not deflation. Deflation is a persistent and ongoing falling price level.

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The Quantity Theory and Deflation • The quantity theory of money explains the trends in inflation by focusing on the trend influences on aggregate supply and aggregate demand. The foundation of the quantity theory is the equation of exchange, which in its growth rate version and solved for the inflation rate states: Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth rate •

•

The quantity theory adds to the equation of exchange two propositions.

• First, the trend rate of change in the velocity of circulation does not depend on the money growth rate and is determined by decisions about the quantity of money to hold and to spend.

• Second, the trend growth rate of real GDP equals the growth rate of potential GDP and, again, is independent of the money growth rate.

With these two assumptions, the equation of exchange becomes the quantity theory of money and predicts that a change in the money growth rate brings an equal change in the inflation rate.

What are the Consequences of Deflation?

The effects of deflation (like those of inflation) depend on whether it is anticipated or unanticipated. But because inflation is normal and deflation is rare, when deflation occurs, it is usually unanticipated.

•

Unanticipated deflation redistributes income and wealth, lowers real GDP and employment, and diverts resources from production.

• Workers with long-term wage contracts find their real wages rising. But employers respond to a higher and rising real wage by hiring fewer workers, so employment and output decrease.

• With lower output and profits, firms re-evaluate their investment plans and cut back on projects that they now see as unprofitable. This fall in investment slows the pace of capital accumulation and slows the growth rate of potential GDP.

An Economics in Action explores the “Fifteen Years of Deflation in Japan.” The Economics in Action feature describes how the deflation was unexpected, which decreased Japan’s economic growth rate, and was the result of monetary growth that was kept too low.

How Can Deflation be Ended?

• Deflation can be ended by removing its cause: The quantity of money is growing too slowly. If the central bank ensures that the quantity of money grows at the target inflation rate plus the growth rate of potential GDP minus the growth rate of the velocity of circulation, then, on average, Money Growth, Not the Quantity of Money • It takes an increase in the growth rate of the money stock, not a one-time increase in the quantity of money, to end deflation.

• Central banks sometimes increase the quantity of money and fail to increase its growth rate.

IV. Inflation and Unemployment: The Phillips Curve A Phillips curve shows the relationship between inflation and unemployment. There are two time frames for a Phillips curve: the short run and the long run.

HISTORY NOTE: The Phillips Curve. As a description of how economics advances, I like to give the students a stylized history of the Phillips curve. The story I tell starts in 1958 when A. W. Phillips published his empirical work. At that time the mainstream economic model was quite different from the AS-AD model derived in the text. Essentially, it was similar to the simple aggregate expenditure model presented in Chapter 11. He had British data that covered a long period of time and so his results appeared to be a long run phenomenon. The model was based on the assumption that the price level was constant, making the inflation rate zero. This assumption was not too unrealistic immediately after World War II. By 1955, however, the inflation rate began to creep higher and averaged 2.7 percent per year between 1956 and 1959. Inflation was beginning to be perceived as a problem, one that a model with a “fixed price level assumption” was poorly suited to solve. .

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In this environment, economists gladly welcomed the simple, short-run Phillips curve, for it gave them a handle on inflation. They believed that they could predict the unemployment rate from their standard model and then combine this unemployment rate with the Phillips curve to determine the resulting inflation rate. The vital assumption in this procedure is that the Phillips curve captures a fixed tradeoff between the actual inflation rate and the unemployment rate that is part of the economy’s structure.

This type of analysis reached its peak of popularity during the early and middle 1960s. By 1967, however, it was under attack. On a theoretical level, economist Milton Friedman—among others—pointed out the flimsy justification behind the simple, fixed Phillips curve assumption. On an empirical level, the simple, fixed Phillips curve failed as the inflation rate rose toward the end of the 1960s and into the 1970s: the unemployment rate did not fall as predicted by the fixed Phillips curve.

At this point the idea of a long-run Phillips curve (as distinct from the short-run one) was developed. The concept that aggregate supply is an important component of macroeconomics was taking hold, as was the idea that short-run Phillips curves shift because of changes in people’s expectations. Thus the profession advanced significantly between the initial discussion of the Phillips curve and what students learn today.

This advance was the result of the interaction between theory, suggesting that the idea of a fixed short-run Phillips curve was inadequate, and empirical work that reinforced the point that the simple, early approach was deficient.

The Short-Run Phillips Curve •

•

The short-run Phillips curve (SRPC) shows the relationship between the inflation rate and the unemployment rate holding constant the expected inflation rate and the natural unemployment rate.

The figure shows a short-run Phillips curve.

Inflation and unemployment have a negative relationship in the short run, so moving along a short-run Phillips curve, a higher inflation rate (holding constant the expected inflation rate) leads to lower a unemployment rate.

The downward sloping short-run Phillips curve is equivalent to the upward sloping short-run aggregate supply curve. When aggregate demand unexpectedly increases so that real GDP and the price level both unexpectedly rise, the increase in real GDP lowers the unemployment rate and the unexpectedly higher price level means there is unexpectedly high inflation. The short-run Phillips curve captures the relationship between the lower unemployment rate and higher inflation rate.

Use the board to create a scatter plot of observations that allow you to later “statistically fit” a line through the points as the Phillips curve. As you make the points on the graph, you can call them out as different years from 1950-1969. Now discuss how policy-makers embraced this model as getting to choose where they want to be on the Phillips curve. You can motivate this by picking two points and asking the students which one they thought would be preferred, high inflation and low unemployment or vice versa.

As government started to think it could “fine-tune the economy,” we began to observe data points that had high inflation and high unemployment. Was Phillips wrong? Ask the students what might have happened and you may get someone to say it shifted! This answer is, of course, correct. Economists started to explore the effect of expected inflation as a factor that shifts the Phillips curve. You can now discuss the distinction between the long-run and the sort-run Phillips curve.

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The Long-Run Phillips Curve •

•

•

The long-run Phillips curve (LRPC) shows the relationship between the inflation rate and the unemployment rate when the actual inflation rate equals the expected inflation rate. As illustrated in the figure, the long-run Phillips curve is vertical at the natural unemployment rate.

The short-run Phillips curve intersects the longrun Phillips at the expected inflation rate. In the figure the expected inflation rate is equal to 4 percent.

In the long run, higher or lower inflation has no effect on the unemployment rate. This result is analogous to the conclusion from the AS-AD model that in long run, a higher or lower price level has no effect on real GDP, which equals potential GDP so that the economy is at full employment.

The Phillips curve and the AS-AD model: Students can become confused about the tie between the Phillips curve and the aggregate supply/aggregate demand (AS-AD) model. Although this relationship is nicely developed in the text, some students will remain baffled. I do not think that a principles course is the appropriate place to derive the link between the two in much detail. But I do think that my lectures are an appropriate place to convey the idea of the relationship. Thus I point out that the vertical long-run aggregate supply curve is analogous to the vertical long-run Phillips curve. If you graph the two side by side, identify potential real GDP and the natural rate of unemployment on the two graphs at the intersection of the long run curves and the horizontal axis. The point that the long-run aggregate supply curve is vertical means that a higher price level has no effect on real GDP and hence no effect on the unemployment rate. Similarly, the fact that the long-run Phillips curve is vertical implies that a higher inflation rate has no effect on the unemployment rate and hence no effect on real GDP. The analogy also carries over to the short-run curves: the positively sloped short-run aggregate supply curve shows that in the short-run an unexpected higher price level raises real GDP and thus lowers unemployment. In the same way, the negatively sloped short-run Phillips curve demonstrates that in the short-run an unexpected higher inflation rate lowers unemployment, thereby raising real GDP. Students find that the two diagrams actually complement each other. I think that this approach is preferable to having the two diagrams compete with each other!

Shifts of the Phillips Curves • •

A change in the expected inflation rate shifts the SRPC vertically upward or downward by the amount of the change but has no effect on the LRPC. A change in the natural unemployment rate shifts both the SRPC and the LRPC. An increase in the natural rate shifts the SRPC and LRPC rightward by the amount of the increase; a decrease shifts the curves leftward by the amount of the decrease.

The U.S. Phillips Curves Because of changes in the expected inflation and the natural rate of unemployment, the short-run Phillips curve has shifted around a lot over time so that there is no single obvious negative relationship between inflation and unemployment. .

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The Economics in the News section analyzes the Eurozone in 2017 showing some slow progress in unemployment while being cautious about inflation.

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Additional Problems 1.

2.

Has the U.S. economy experienced inflation or deflation during recent recessions? Explain.

The spreadsheet provides information about the economy in Argentina. Column A is the year, Column B is real GDP in billions of 2000 pesos, and Column C is the price level. a. In which years did Argentina experience inflation?

In which years did it experience deflation (a falling price level)? b. In which years did recessions occur? In which years did expansions occur? c. In which years do you expect the unemployment rate was highest? Why? d. Do these data show a relationship between unemployment and inflation in Argentina?

1 2 3 4 5 6 7 8 9 10 11 12

A 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

B 277 288 278 276 264 235 256 279 305 331 359 384

C 105.6 103.8 101.9 102.9 101.8 132.9 146.8 160.4 174.5 198.0 226.1 267.7

Solutions to Additional Problems 1,

2.

The United States has experienced inflation during recent recessions, though there have been instances when the inflation rate fell during recessions. For instance in late 2018 the inflation rate fell as the economy moved into a recession. Inflation, however, generally continued because aggregate demand continued to increase during the recessions, though at a slower rate. a. Argentina experienced inflation in 2010 and from 2012 through 2018. Argentina experienced deflation in 2008, 2009, and 2011. b. Argentina had recessions in 2009, 2010, 2011, and 2012. Argentina had expansions in 2008 and 2013 through 2018. c. The unemployment rate was probably high in all of the recessionary years. It was probably the highest in 2010 and 2012 when the recessions were at their worst. d. There is not a strong relationship between unemployment and inflation in the data. The unemployment rate would likely have been higher in the recession years of 2009, 2010, 2011, and 2012. In 2010 Argentina experienced low inflation and 2012 Argentina experienced high inflation.

In 2009 and 2011 Argentina experienced deflation. But Argentina also experienced deflation 2008.

So there is no consistent relationship between either inflation and high unemployment or deflation and high unemployment. There also is a similar lack of relationship between inflation and low unemployment or deflation and low unemployment.

Additional Discussion Questions 11. Some economists claim that inflation is always a “monetary phenomenon.” What do they mean by this claim and are they correct? This claim points to the result that an ongoing inflation requires the central bank to constantly increase the quantity of money. In the absence of continual monetary growth, the price level might rise but it would eventually stabilize. The price level will continue to rise, which means that on-going inflation will occur, only if the Federal Reserve constantly increases the quantity of money. Because .

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inflation requires constant growth in the quantity of money, inflation can be thought of as a “monetary phenomenon.”

12. How can a higher price of oil create inflation? By itself a higher price of oil cannot create inflation. Taken by itself a higher price of oil can lead to a higher price level but after the adjustment is made to the higher price of oil, the price level stops rising—that is, inflation stops. A higher price of oil can lead to inflation only if the central bank “ratifies” it by increasing the quantity of money. If the central bank, the Federal Reserve in the United States, responds to the decrease in real GDP created by the higher price of oil by increasing the quantity of money, then inflation can result. The increase in the quantity of money will drive the price level still higher. In this situation oil producers might respond by again boosting the price of oil. If the Fed responds once again in turn, the process can continue indefinitely and a cost-push inflation results.

13. What is the relationship between the short-run aggregate supply curve and the shortrun Phillips curve? Between the long-run aggregate supply curve and the long-run Phillips curve? The short-run aggregate supply curve and the short-run Phillips curve are closely related. If aggregate demand increases, the economy moves upward along its shortrun aggregate supply curve so that the price level and real GDP both increase. The rise in the price level means that inflation rises and the increase in real GDP means that unemployment falls. The rise in the inflation rate combined with the fall in the unemployment rate correspond to a movement upward along the economy’s short-run Phillips curve. Similarly the long-run Phillips curve and long-run aggregate supply curve also are closely related. In the long run an increase in aggregate demand moves the economy upward along its long-run aggregate supply curve so that the price level rises and real GDP does not change—it remains equal to potential GDP. The rise in the price level means that the inflation rate rises and the result that real GDP remains equal to potential GDP means that the unemployment rate remains equal to its natural rate. The rise in the inflation rate combined with the unemployment rate remaining equal to its natural rate correspond to a movement upward along the economy’s long-run Phillips curve.

14. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent while the expected inflation rate remains at 7 percent, what happens to the unemployment rate? If the actual inflation rate falls and the expected inflation rate does not change, the economy moves downward along a short-run Phillips curve so that the unemployment rate increases.

15. Suppose the expected and actual inflation rates are 7 percent and the natural rate of unemployment is 6 percent. If the inflation rate falls to 5 percent and the expected inflation rate also falls to 5 percent, what happens to the unemployment rate? If the actual inflation rate and the expected inflation rate fall by the same amount, the economy moves downward along its long-run Phillips curve so that the unemployment rate does not change—it remains equal to the natural unemployment rate.

16. Suppose that the actual inflation rate is 7 percent and that the economy is at the natural unemployment rate. If the Fed announces that it is going to lower the inflation rate and people believe this announcement (so that the decline in the inflation rate is not a surprise), what happens to the unemployment rate? Suppose that people believe the Fed’s announcement and that the expected inflation rate falls, but then the Fed keeps the inflation rate at 7 percent. Now what happens to the unemployment rate? If the Fed follows through on its announcement, both the actual and expected inflation rate fall by the same amount so that the unemployment rate remains equal to its natural rate. .

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However if the Fed actually does not lower the inflation rate, then the actual inflation rate exceeds the expected inflation rate. In this case the short-run Phillips curve shifts downward. The economy moves to a point on its new short-run Philips curve at the unchanged inflation rate and the unemployment rate falls.

17. How do you think recessions influence elections? Recessions have large impacts on elections. If an election occurs during (or near) a recession, the incumbent party suffers.

This empirical result holds true for President Ford who lost his reelection bid in 1976; President Carter who lost his reelection bid in 1980; President Bush who lost his reelection bid in 1992; and Senator McCain who lost his election bid in 2008. All of these candidates were members of the incumbent party and all faced election either near or during a recession. President Obama’s re-election in 2012 was an unusual case in that the economy was in recovery but unemployment was still high near 8 percent.

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FISCAL POLICY

The Big Picture Where we have been: This chapter extensively uses the aggregate supply-aggregate demand model introduced in Chapter 10. It also makes use of Chapter 11’s discussion of multipliers. The material on the labor market and potential GDP from Chapter 6 is important when discussing the supplyside effects of fiscal policy.

Where we are going: Chapter 14 on monetary policy completes the material on macroeconomic stabilization policies. The discussion on debt and deficits from this chapter are good preparation for some of the monetary policy responses the Fed can use in the next chapter.

New in the Thirteenth Edition This chapter is rich with data, which has all been updated to 2017. The Economics in the News feature at the end of the chapter discusses a 2017 article on Trump’s proposed cuts to the corporate tax rate. It shows a nice application of the impact of a corporate tax reduction in the loanable funds market along with other analysis of dynamic versus static scoring. The topics of the U.S. deficit in mid-2017, the Trump budget and deficit, a VAT for America, mandatory spending is hard to control, China’s infrastructure spending, and hurricane Irma and Harvey fiscal questions are all new current event questions from article clips in the end-of-chapter exercises.

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Lecture Notes

Fiscal Policy • •

I.

Fiscal policy refers to changes in government expenditure and taxes.

Fiscal policy impacts both aggregate supply and aggregate demand.

The Federal Budget

The annual statement of the outlays and receipts of the government of the United States together with the laws and regulations that approve and support those outlays and receipts make up the federal budget. The use of the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is called fiscal policy.

The Institutions and Laws •

•

The President submits a budget proposal to Congress. Congress debates, amends, and enacts the budget. The budget operates within the framework of the Employment Act of 1946, which states: “… it is the continuing policy and responsibility of the Federal Government to use all practicable means … to coordinate and utilize all its plans, functions, and resources … to promote maximum employment, production, and purchasing power.”

The Council of Economic Advisers monitors the economy and keeps the President and the public well informed about the current state of the economy and the best available forecasts of where it is heading.

Highlights of the 2018 Budget • • •

Receipts come from four sources: personal income taxes ($1,836 billion), social security taxes ($1,224 billion), corporate income taxes ($355 billion), and indirect taxes and other receipts ($239 billion).

Outlays are classified in three categories: transfer payments ($2,947 billion), expenditure on goods and services ($1,832 billion), and debt interest ($315 billion).

Budget balance = Receipts – Outlays • If receipts exceed outlays, the government has a budget surplus.

• If outlays exceed receipts, the government has a budget deficit.

• If receipts equal outlays, the government has a balanced budget.

The U.S. Budget in Historical Perspective and in Global Perspective • • •

Since 1990, except between 1998 to 2001, the U.S. government has had a budget deficit.

Government debt is the total amount that the government has borrowed. A budget deficit adds to the government debt.

In 2017, all of the world’s major economies except Germany had a budget deficit. The newly industrialized economies of Asia had the smallest deficits while Japan, the United States, the United Kingdom (in that order) had the largest deficits as a fraction of GDP. The U.S. deficit was about 5 percent of GDP.

Deficit and debt. Many students need help with the distinction between the deficit and the debt (and with what happens to the debt when there is a surplus). Use the student loan or credit card analogy. Explain that the budget balance (the deficit or surplus) is just like a personal budget balance (the amount that a student borrows or pays back during a given year). The debt—the total amount owed by the government—is like the balance on a student loan or credit card account. Students (usually) have a budget deficit and increasing debt. And graduates with a job (usually) have a budget surplus and decreasing debt.

An interesting historical episode. During the mid-1830s—a long time ago—the U.S. government had virtually repaid all its debt. At that time the government faced a problem that doesn’t occur today: it had a surplus and didn’t know what to do with it. The decision was made to transfer money to the state .

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governments. Each state was to receive $400,000 in four payments of $100,000 each. The first three payments were made, but the last one was postponed because of a recession in 1837 that lowered the federal government’s revenue and then was never made. In the 1970s, faced with a severe budget crunch, the State of New York sued to receive that last payment plus interest. The state lost the suit and so the last payment probably will never be made! (You might remark that $100,000 invested in 1837 at the average interest rate would have accumulated to about $30 billion by 2015!)

II. Supply-Side Effects of Fiscal Policy The effects of fiscal policy on employment, potential GDP, and aggregate supply are known as supply-side effects.

The Effects of Taxes on Full Employment and Potential GDP • •

•

•

•

The labor market determines the full employment quantity of labor, which, together with the production function, determine potential GDP. The equilibrium quantity of employment is determined in the labor market. The first figure shows the labor market. In the figure equilibrium employment is 250 billion hours per year. This amount of employment is full-employment.

The second figure shows the production function.

With employment of 250 billion hours, the production function shows that real GDP is $18 trillion.

An income tax decreases the supply of labor and shifts the supply of labor curve leftward. In the top figure, the LS curve shifts leftward. Because of the tax wedge, the level of employment decreases. In the bottom figure the decrease in employment decreases potential GDP. An income tax drives a tax wedge between the before-tax wage rate that firms pay and the aftertax wage rate that workers receive. Other taxes, such as sales taxes, add to the tax wedge by effectively lowering the real wage rate.

Some Real World Tax Wedges … Does the Tax Wedge Matter?

Tax wedges vary across countries, being much higher in France than in the United States. According to supply-side economists such as Ed Prescott, the tax wedge has a large impact on potential GDP. Potential GDP per person in France is 30 percent below that in the United States and Prescott asserts that the entire difference can be attributed to the difference in the countries’ tax wedges.

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Taxes and the Incentive to Save and Invest •

•

A tax on interest income decreases the supply of saving and shifts the supply of loanable funds curve leftward. The tax drives a wedge between the after-tax interest rate received by savers and the interest rate paid by firms. The tax does not change the demand for loanable funds. The figure shows the result: the real interest rate paid by borrowers rises (from 5 percent to 6 percent in the figure) and the equilibrium quantity of loanable funds and investment decrease.

The decrease in investment lowers the growth rate of potential GDP.

Tax Revenues and the Laffer Curve •

•

The relationship between the tax rate and the amount of tax collected is called the Laffer curve. The Laffer curve shows that at a high enough tax rate, an increase in tax rates decreases tax revenues. Tax revenues decrease because individuals find ways to avoid the high taxes, including by working less.

Most economists believe that taxes have an effect on the supply of labor, but that in the U.S. economy, the tax rate is low enough so that an increase in the tax rate increases tax revenues.

Laffer Curve and Napkins: Students get a kick out of the napkin roots of the Laffer Curve. The story that Laffer himself cannot deny nor confirm is that he first drew the Laffer curve on a napkin during one of his first attempts to persuade someone of his supply side theory. Draw the Laffer curve and ask what side of the curve are we on? Ask them what they think the highest tax rate was in the United States, they are usually shocked to learn that we had marginal rates in the 70% range as recently as the 1970. This a great discussion point on how high tax rates can deter work!

Consumption Tax: Students enjoy exploring the controversial idea of abolishing the IRS in favor of a consumption tax. Whether you agree with it or not, the Fairtax plan (Google Fairtax plan to find the website) covers many issues from this chapter and is an awesome way to bring together many of the topics from the course. Students engage with the concept of a revenue neutral switch from our mixed tax system to 100% consumption tax. I assign a short paper for them to investigate one of the many sub-topics within the plan.

The Economics in the News detail compares the U.S. corporate tax rate with those in other countries and explores how the tax wedge affects the U.S. loanable funds market.

III. Generational Effects of Fiscal Policy Generational accounting is an accounting system that measures the lifetime tax burden and benefits of government programs to each generation.

Generational Accounting and Present Value To compare the costs and benefits that occur at different points in the future, which is necessary in generational accounting, the concept of present value is used. A present value is an amount of money that, if invested today, will grow to equal a given future amount when the interest that it earns is taken into account. Because there is uncertainty about the proper interest rate to use when calculating present values, plausible alternative numbers are used to estimate a range of present values. .

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The Social Security Time Bomb •

•

Fiscal imbalance is the present value of the government’s commitments to pay benefits minus the present value of its tax revenues. In 2014, the fiscal imbalance was estimated to be $68 trillion and growing by about $2 trillion every year. The fiscal imbalance is high because of obligations under Social Security laws and Medicare.

There are four alternatives for redressing the fiscal imbalance: raise income taxes, raise Social Security taxes, cut Social Security benefits, or cut federal government discretionary spending. But the changes needed would be severe. It is estimated that income taxes would need to be raised by 69 percent; or Social Security taxes raised by 95 percent; or Social Security benefits cut by 56 percent.

Generational Imbalance Generational imbalance is the division of the fiscal imbalance between the current and future generations assuming that the current generation will enjoy the current levels of taxes and benefits. It is estimated that the current generation will pay 83 percent of the fiscal imbalance and the future generations will pay 17 percent.

IV. Fiscal Stimulus • •

A fiscal action that is initiated by an act of Congress is called discretionary fiscal policy.

A fiscal action that is triggered by the state of the economy is called automatic fiscal policy.

Automatic Fiscal Policy and Cyclical and Structural Budget Balances •

• •

Tax revenues and needs-tested spending change with the business cycle.

• The government sets tax rates. As incomes vary with the business cycle, the tax revenue collected changes. Tax revenue automatically falls in recessions and automatically rises in expansions.

• Government expenditure on programs that pay benefits to people and businesses depending on their economic status is called needs-tested spending. Needs-tested spending automatically increases in a recession and automatically decreases in an expansion, helping to stabilize the economy.

Induced taxes and needs-tested spending mean that the federal budget deficit is counter-cyclical, with the deficit increasing in a recession and decreasing in an expansion.

The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual surplus or deficit minus the structural surplus or deficit.

• In 2017 the total U.S. budget deficit was $440 billion. According to the Congressional Budget Office (CBO) the cyclical deficit was $410 billion so the structural deficit was $30 billion.

• The structural deficit skyrocketed after 2008.

By their nature, automatic fiscal policy implies federal budget deficits in recessions as tax revenues fall and spending increases. By contrast, balanced budget rules for state and local governments mean that these governments do not conduct stabilizing fiscal policy. In the 2008 recession, the sharp decline in state and local tax revenues meant that state spending programs had to be cut and, in some states, taxes raised. Such policies are the opposite of the policies that can be used to help stabilize the business cycle.

•

Automatic fiscal policy helps stabilize the business cycle because it provides an automatic stimulus during a recession and an automatic contraction during an expansion.

Discretionary Fiscal Stimulus •

The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP. An increase in government expenditure increases aggregate expenditures setting in motion the multiplier process. .

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•

The tax multiplier is the quantitative effect of a change in taxes on real GDP. A decrease in taxes increases disposable income and hence consumption expenditure, setting in motion the multiplier process.

• The effect on aggregate demand from a tax cut is less than that from a similar sized increase in government expenditure. A $1 tax cut generates less than a $1 increase in consumption expenditure since only a fraction (equal to the MPC) of the $1 increase in disposable income is spent on consumption expenditure.

Fiscal Stimulus •

•

Expansionary fiscal policy (an increase in government expenditure or a decrease in taxes) seeks to eliminate a recessionary gap. If timed correctly and of the correct magnitude, fiscal policy can be used to push the economy to potential GDP. The figure shows the effect of expansionary fiscal policy on aggregate demand. At the initial equilibrium, $17 trillion real GDP and price level of 110, there is a recessionary gap. The expansionary policy increases aggregate demand and the multiplied effect shifts the AD curve rightward from AD0 to AD1. The recessionary gap is eliminated and the economy moves to its new equilibrium, $18 trillion real GDP (which equals potential GDP) and price level of 115.

Fiscal Stimulus and Aggregate Supply

The focus so far has been on only aggregate demand. But fiscal policy also impacts aggregate supply.

• Government Expenditure: An increase in government expenditure increases the budget deficit. The demand for loanable funds increases, so the real interest rate rises and investment is crowded out.

The decrease in investment offsets the expansionary effect from the increase in government expenditure. The crowding-out effect is strong enough so that the government expenditure is less than 1.

• Tax Cut: A tax cut also has effects on aggregate supply. A tax cut increases the supply of labor and the supply of loanable funds, both of which increase aggregate supply. The supply-side effects make the tax multiplier larger than the government expenditure multiplier.

There is quite a bit of controversy about the size of the multipliers and this controversy is nicely covered in an Economics in Action detail. Christina Romer, while working for the Obama administration, asserted that the government expenditure multiplier was 1.5. Robert Barro, of Harvard University, says his research shows the multiplier is 0.5. These differences are dramatic and students can appreciate their importance and real-world relevance. Highlight the Ricardo-Barro effect as a possible argument for smaller multipliers.

Limitations of Discretionary Fiscal Policy In practice, discretionary fiscal policy is hampered by three time lags: • • •

Recognition Lag: The recognition lag is the time it takes to figure out that fiscal policy actions are needed.

Law-Making Lag: The law-making lag is the amount of time it takes Congress to pass the laws needed to change taxes or spending.

Impact Lag: The impact lag is the time it takes from passing a tax or spending change to implementing the new arrangements and feeling their effects on real GDP. .

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Fiscal policy in practice. Most economists acknowledge that, in principle, discretionary fiscal policy can be used for stabilization purposes, but in practice such stabilization is extremely difficult because of long legislative lags. It is worth reminding the students that the equilibrium in the AS-AD model takes time to work out. The multiplier is a long drawn out process. An increase in government expenditure shifts the AD curve rightward but the new equilibrium price level and real GDP take time to occur. It is also useful to discuss the length of time it took the Congress to pass the 2002 “stimulus package” and the time it took in the Fall of 2008 to decide on a fiscal policy to be used after the initial “bailout package.” The law-making lag can be substantial and the outcomes questionable!

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Additional Problems 1.

The government is proposing to lower the tax rate on labor income and asks you to report on the supply-side effects of such an action. Answer the following questions and describe what happens on the relevant graph. You are being asked about directions of change, not exact magnitudes. a. What will happen to the supply of labor and why? b. What will happen to the demand for labor and why? c. What will happen to the equilibrium level of employment and why? d. What will happen to the equilibrium before-tax wage rate? e. What will happen to the equilibrium after-tax wage rate? f. What will happen to potential GDP?

2.

How Reagan Would Fix the Economy Many Republicans look at Reagan’s policies in the early 1980s and assert that tax cuts pay for themselves. That’s wrong—Reagan’s rate cuts for the rich paid for themselves, but the tax cuts for the poor, the middle class and corporations did not. The deficit increased. But there is a limit to the deficit. At some time the government debt grows so large that it starts to harm the economy through higher interest rates, bigger debt payments, a weaker currency, etc.

Time, May 26, 2008 a. Explain why Reagan’s tax rate cuts for high income taxpayers may have paid for themselves, but cuts for lower-income and middle-income taxpayers did not. b. Explain the negative consequences of running persistently large budget deficits.

3.

Explain why extending unemployment insurance benefits has both a supply-side and demand-side effect on real GDP and the price level.

Solutions to Additional Problems 1.

a.

b. c.

d. e.

f.

2.

a.

The supply of labor increases. The supply of labor curve shifts rightward. The supply of labor increases because at each real wage rate, the after-tax wage rate received by workers will be higher given a decrease in the tax rate on labor income.

The demand for labor remains the same. The demand for labor depends on the productivity of labor, which remains the same following the decrease in the tax rate on labor income.

The equilibrium level of employment increases. With the rightward shift in the supply of labor curve, the real wage rate decreases and the quantity of labor demanded increases along the demand for labor curve. Equilibrium employment increases.

The equilibrium pre-tax wage rate decreases. The rightward shift of the supply of labor curve leads to movement down along the demand for labor curve.

The equilibrium after-tax wage rate increases. The decrease in the tax rate on labor income decreases the wedge between the before-tax wage rate and the after-tax wage rate. The before-tax wage rate decreases but not by as much as the decrease in tax. So the after-tax wage rate increases.

Potential GDP increases. The equilibrium level of employment is the full employment quantity of labor. So as full employment increases, potential GDP increases along the production function.

High-income taxpayers faced very high tax rates. For these taxpayers, the cut in tax rates probably lead to large increases in the quantity of labor they supplied so that the tax revenue from high.

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income taxpayers increased. But middle-income and lower-income taxpayers did not face such high rates. For these groups the tax cut increased the quantity of labor they supplied but by only a small amount so that the tax revenue from middle-income and low-income taxpayers decreased.

Persistently running large budget deficits increases the government debt, which increases the interest the government must pay and contributes to larger budget deficits in the future. Budget deficits also crowd out investment, so persistently running budget deficits decreases investment and the capital stock is less than otherwise. Because the capital stock is smaller, U.S. potential GDP is lower.

Extending unemployment insurance benefits increases the amount of time unemployed workers search for new jobs, which decreases employment. The decrease in employment decreases aggregate supply. Simultaneously extending unemployment insurance benefits increases the income received by unemployed workers. The increase in income increases consumption expenditure, which increases aggregate demand.

Additional Discussion Questions 11. What is the distinction between the government’s budget deficit and the government’s debt? The budget deficit is the amount the government is borrowing in any given year. The government debt is the total amount the government has borrowed over all the years. The budget deficit adds to the (total) government debt.

12. Suppose that the government increases its expenditures payments by $100 billion and pays for the increase by raising taxes by $100 billion. What is the effect on aggregate demand and real GDP of each change individually and of the two combined? The increase in government expenditure adds directly to aggregate demand so that aggregate demand and real GDP both increase. The increase in taxes indirectly decreases aggregate demand by decreasing consumption expenditure. The decrease in aggregate demand leads to a decrease in real GDP. The magnitude of the increase in aggregate demand from the increase in government expenditure exceeds the magnitude of the decrease from the increase in taxes. So when both effects are combined, on net aggregate demand increases so that real GDP increases.

13. Why does a change in income taxes have a different effect on aggregate supply than a change in government expenditures? A change in income taxes changes the tax wedge and affects people’s incentives to supply labor. The supply of labor changes, which affects employment and hence potential GDP. For example, if income taxes are boosted, the supply of labor decreases. With the decrease in the supply of labor, employment decreases so that potential GDP decreases. The decrease in potential GDP decreases aggregate supply. A change in government expenditures does not have this same incentive effect. Because it does not have this effect, it has no impact on aggregate supply.

14. Suppose because of a recession, most state governments experience reductions in tax revenues, and respond by reducing their expenditures and increasing their taxes to keep their state budgets in balance (a constitutional requirement in many U.S. states).

Will this have any effect on the recession, and if so, what? This policy on the part of states deepens the recession. In a recession fiscal policy generally aims to increase aggregate demand because the increase in aggregate demand increases real GDP. Cutting state government spending and raising taxes decreases aggregate demand. A decrease in aggregate demand decreases real GDP and worsens the recession.

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5. In 2012, the looming “Fiscal Cliff” meant that there would be an increase in taxes coupled with a decrease in government spending. Meanwhile the Federal Reserve was continuing “Quantitative Easing.” Discuss the combined effects of these events on the economy. The fiscal cliff is a combination of two contractionary fiscal policies which would decrease aggregate demand. Quantitative Easing is an expansionary monetary policy meant to increase aggregate demand. Chairman Bernanke stated during the fourth quarter of 2012 that the Fed was pursuing that policy in part to hedge against the negative effects of the fiscal cliff should it happen.

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MONETARY POLICY**

The Big Picture Where we have been: Chapter 14 heavily uses material from Chapter 8, which was the first chapter dealing with money, and Chapter 10, which introduced the aggregate supply-aggregate demand model.

The expenditure multiplier, covered in Chapter 11, plays a small role in this chapter. Playing a larger role is the loanable funds market, developed in Chapter 7.

Where we are going: Chapter 14 is the last chapter dealing with macroeconomics. The next chapter, on international trade, will not use the material from this chapter and could be covered before you get into Chapter 4.

New in the Thirteenth Edition This chapter has new content and is slightly reorganized. The Conduct of Monetary Policy section now has a subsection “Implementing the Policy Decision” which explains the market for reserves and the “corridor” for the federal funds rate created by the policy choice variables of the discount rate and interest on reserves. The Taylor rule is now included in the Monetary Policy Transmission section explaining policy strategy and clarity. The new content of the chapter is at the end under the heading Financial Crisis: Cure and Prevention. Macroprudential regulation is covered in general with short paragraphs laying out the basics of Glass-Steagall, Dodd-Frank and the Volcker Rule. The Economics in the News features a 2017 article about the Fed removing stimulus to the economy and unwinding its balance sheet. There are five new end-of-chapter exercises including: Fed sees low unemployment and inflation, IMF sees global speedup, Wall Street hates Volcker Rule, debt/GDP ratio poses questions for Fed, and FOMC policy decision lowers the U.S. exchange rate.

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* This is Chapter 31 in Economics. .

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Lecture Notes

Monetary Policy • • • •

I.

Describe the objectives of U.S. monetary policy and the framework for setting and achieving them Explain how the Federal Reserve makes its interest rate decision and achieves its interest rate target Explain the transmission channels through which the Federal Reserve influences real GDP, jobs, and inflation Describe the Fed’s actions and macroprudential regulations prompted by the 2008 financial crisis

Monetary Policy Objectives and Framework

Monetary Policy Objectives The Fed’s mandate is that “The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long-run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

•

Goals: The goals in the mandate are “maximum employment, stable prices, and moderate longterm interest rates.” Achieving stable prices, keeping the inflation rate low, is the key. It is the source of maximum employment and moderate long-term interest rates. Low inflation rates mean that people make decisions without the confusion created by inflation. And, because the nominal interest rate equals the real interest plus the inflation rate, a low inflation rate means low longterm interest rates.

• Operational “Stable Prices” Goal: The Fed pays close attention to the core PCE deflator, the PCE deflator excluding food and fuel. The core inflation rate is the rate of increase of the core PCE deflator. Price stability can mean either a core inflation rate “low and stable enough so that it does not enter materially into the decisions of households and firms” (Alan Greenspan) or a core inflation rate of “1 or 2 percent” (Ben Bernanke).

•

Operational “Maximum Employment” Goal: The Fed tracks the output gap, the percentage deviation of real GDP from potential GDP. The Fed tries to minimize the output gap.

Responsibility for Monetary Policy •

• •

The Role of the Fed The Federal Reserve Act makes the Board of Governors of the Federal Reserve System and the Federal Open Market Committee (FOMC) responsible for the conduct of monetary policy. The Fed has ultimate responsibility for monetary policy. The FOMC makes monetary policy decisions at eight scheduled meetings a year.

The Role of Congress Congress plays no role in making monetary policy decisions but the Federal Reserve Act requires the Board of Governors to report on monetary policy to Congress.

The Role of the President The formal role of the president of the United States is limited to appointing the members and the chairman of the Board of Governors.

II. The Conduct of Monetary Policy The Monetary Policy Instrument A monetary policy instrument is a variable that the Fed can directly control or closely target.

• •

The Fed could fix the exchange rate as its policy instrument. But then it could not pursue an independent monetary policy, so for that reason the Fed does not fix the exchange rate.

The Fed, similar to most central banks, chooses to use a short-term interest rate as its monetary policy instrument. The interest rate the Fed targets is the federal funds rate, the interest rate on overnight loans (of reserves) that banks make to each other. Although the Fed can change the .

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•

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federal funds rate by any reasonable amount, it normally changes the federal funds rate one quarter of a percentage point at a time.

The federal funds rate is determined in the market for reserves.

The higher the federal funds rate, the greater the opportunity cost of holding reserves rather than loaning them. So the higher the federal funds rate, the smaller the quantity of reserves demanded. As shown in the figure, the demand curve for reserves is downward sloping.

The Fed’s open market operations determine the supply of reserves. Because the Fed determines the quantity of reserves, the figure shows that the supply curve of reserves is vertical at this quantity.

The discount rate sets a cap on the federal funds rate because a bank will not borrow from another bank if the federal funds rate exceeds the rate at which it can borrow from the Fed, the discount rate. The interest rate paid on reserves sets a lower bound for the federal funds rate because a bank will not loan its reserves if the federal funds rate is lower than the interest rate it receives on its reserves.

• An Open Market Purchase: The Fed buys government securities from a bank and pays for the purchase by increasing the bank’s reserves. The supply of reserves increases.

• An Open Market Sale: The Fed sells government securities to a bank and receives payment for the sale by decreasing the bank’s reserves. The supply of reserves decreases.

The figure shows the market for reserves. In the figure the equilibrium federal funds rate is 5 percent.

• If the Fed wants to lower the federal funds rate, the Fed undertakes an open market purchase of government securities. The quantity of reserves increases and the federal funds rate falls.

•

If the Fed wants to raise the federal funds rate, the Fed undertakes an open market sale of government securities. The quantity of reserves decreases and the federal funds rate rises.

Interest Rate Determination: The reason that an increase in the reserves lowers the interest rate can be easily developed by focusing on banks. Using an open market operation, the Fed increases unplanned reserves. Banks want to loan these new unplanned reserves, and thus the supply of loans and loanable funds increases. As a result, the interest rate on loans falls as they struggle to make more loans. This type of intuitive explanation often can be quite helpful in supplementing the formal analysis.

FOMC Decision Making and the Market for Reserves After assessing the current state of the economy using the Beige book (which is now online), the Fed turns to forecasting three key variables: the inflation rate, the unemployment rate, and the output gap. Based on those forecasts, The FOMC formulates its monetary policy and decides upon its target federal funds rate.

The FOMC instructs the New York Fed to use open market operations—the purchase or sale of government securities in the open market—to hit its federal funds target rate.

Interest on Reserves: You may want to mention that because of the 2008 financial crisis, the Fed accelerated its plan to implement paying interest on reserves. This change effectively created a lower bound for the federal funds rate and added another tool to the Fed’s toolbox. A relevant article on the subject can be found on the San Francisco Fed website entitled “Why did the Federal Reserve start paying

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interest on reserve balances held on deposit at the Fed? Does the Fed pay interest on required reserves, excess reserves, or both? What interest rate does the Fed pay?”

III. Monetary Policy Transmission Ripple Effects of Changing the Interest Rate Suppose the Fed lowers the federal funds rate using an open market sale. As a result: • • • • • •

Other interest rates: Other short-term interest rate falls. Long-term bond interest rates also fall, but by a lesser amount.

Exchange rate: The fall in the U.S. interest rate lowers the U.S. interest rate differential. The demand for U.S. dollars decreases and the supply of U.S. dollars increases. The exchange rate falls (the dollar depreciates).

Money and bank loans: Banks’ reserves have increased so they have excess reserves. Banks loan the excess reserves, so loans and the quantity of money increases.

Long-term real interest rate: The real interest rate is determined in the loanable funds market. In the short run, the increase in loans increases the supply of loanable funds and lowers the real interest rate.

Expenditure plans: Consumption expenditure and investment increase as a result of the lower real interest rate. Net exports increase as a result of the fall in the exchange rate.

Aggregate demand: Aggregate demand increases with a multiplier effect so that the price level rises and real GDP increases.

Effects of Money on Real GDP and the Price Level: We bring in here the expenditure multiplier; it is important to ensure that students do not get confused between the multiplier impact of open market operations on the quantity of money, and the multiplier process that magnifies autonomous expenditure changes. Additionally, when using the AS-AD model to explain the impact of deflationary monetary policy, it is important to stress the text’s point that the model is a stationary simplification, whereas in reality output and the price level both tend to grow, so that rather than reducing real GDP and the price level, the Fed’s anti-inflation policy would slow their growth.

The Fed Fights Recession If the Fed believes that real GDP is less than potential GDP (a negative output gap), the Fed will undertake expansionary monetary policy: it lowers the federal funds rate using an open market sale. The monetary policy is transmitted as outlined above and real GDP increases.

The Fed Fights Inflation If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem (a positive output gap), the Fed will undertake contractionary monetary policy: it raises the federal funds rate using an open market sale. The effect of the monetary policy is transmitted as described, only the directions of the changes are reversed. Real GDP decreases.

Tying it All Together: Students often think that macroeconomics is difficult because there are so many different concepts introduced. Among others, students must learn about aggregate demand curve and the short-run and long-run aggregate supply curves; the aggregate production function; ; the demand for labor, the supply of labor, and the labor market; the demand for reserves, the supply of reserves, how Fed policy affects the supply of reserves, and the market for reserves; the demand for money, the supply of money, the money multiplier, and the market for money; and, the demand for loanable funds, the supply of loanable funds, the market for loanable funds, and government impacts on this market. This chapter offers a great chance for you to use the book’s very clear presentation and very straightforward presentation of monetary policy transmission to help the student see how all the parts interact. Use the book’s “four quadrant diagrams” (Figures 14.6a, 14.6b, 14.6c, and 14.6d as well as 14.7a, 14.7b, 14.7c, and 14.7d) to .

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show the students how everything they learned ties together to give a complete and coherent view of the otherwise exceedingly complex macroeconomy. Don’t hesitate to refer back to earlier chapters to remind the students what they learned in those chapters and how that is now being used to explain how our economy functions.

Loose Links and Long and Variable Lags •

In reality, the ripple effects of monetary policy are not as precise as outlined above.

• The long-term real interest rate that influences expenditure plans is linked only loosely to the federal funds rate. And the response of expenditure plans to the real interest rate also is not tight.

•

•

The transmission channels described above take time to operate and the time can vary from one episode to the next.

In the United States, when the federal funds rate rises relative to the long-term bond rate, a year later real GDP growth generally slows.

The Economics in the News section details how the Fed plans to unwind its historical balance sheet of short- and long-term securities.

Policy Strategies and Clarity Two alternative decision-making strategies have been proposed. Both strive to create greater openness and certainty about the Fed’s monetary policy.

Inflation Rate Targeting •

Inflation rate targeting is a monetary policy strategy in which the central bank makes a public commitment to achieve an explicit inflation target and to explain how its policy actions will achieve that target. Other countries (England, New Zealand, Canada, Sweden, and the EU) have successfully used inflation targeting rules to keep their inflation rate low.

Taylor Rule •

The Taylor rule uses a formula to set the target federal funds rate. The Taylor rule sets the federal funds rate (FFR) at the equilibrium real interest rate, assumed to be 2 percent, plus amounts based on the inflation rate (INF) and the output gap (GAP) according to: FFR = 2 + INF + 0.5(INF − 2) + 0.5GAP John Taylor says that the Fed has come close to following this rule but if it had followed it precisely the economy would have performed better.

Why Rules?

•

Rules are important because rules enable households and firms to form more accurate inflation expectations. Markets work best when inflation expectations are most accurate and rules allow accuracy in inflationary expectations.

Effects of Money on Real GDP and the Price Level Revisited: You might want to remind the students that the effects of monetary policy on real GDP and the price level so clearly discussed in this chapter are short run effect. In the long run, the quantity theory covered in Chapter 8 rules the roost. You can point out to your students that in the long run, the impact on real GDP dissipates and the only long run effect is on the price level (or the inflation rate). In the late 1970s and early 1980s, several central banks targeted the quantity of money to successfully lower their inflation rates. However, central banks eventually abandoned this procedure as financial innovations made the demand for money (and velocity) mush less stable than in the past.

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IV. Financial Crisis: Cure and Prevention The Key Elements of the Crisis The financial crisis of 2007-2008 started in the United States in August 2007. Banks were at the center of the crisis which eventually led to the largest recession since the great depression.

•

• •

Banks were put under stress from three sources: • A Widespread Fall in Asset Prices: The so-called “housing bubble” burst and house prices rapidly switched from rising to falling. Sub-prime mortgage defaults occurred and these assets as well as derivatives based on these assets lost value. Banks suffered losses which reduced their equity.

• A Significant Currency Drain: Depositors started to withdrawal their deposits at money market mutual funds. This process created concern among banks that similar withdrawals would occur and that bank runs might start.

• A Run on the Bank: When depositors lose confidence in a bank, massive withdrawals of deposits occur. Banks’ desired reserves increased so banks increased their reserves by calling in loans.

• The widespread fall in asset prices threatened banks’ solvency; the currency drain threatened their liquidity; and, the potential run on the bank threatened both solvency and liquidity.

Banks’ efforts to shore up their balance sheet severely decreased the supply of loans and commercial paper, so these markets essentially closed. Because the loanable funds market is worldwide, these problems immediately spread throughout the world.

The drastic decrease in the supply of loanable funds started to affect the real economy.

The Policy Actions •

Policy actions responding to the crisis were slowly implemented: • Open Market Operations: The Fed undertook massive open market operations to give banks more liquidity. The federal funds rate was lowered, in December to between 0.00 and 0.25 percent.

• Purchase of Mortgage-Backed Securities: The Fed purchased significantly riskier assets, in particular mortgage-backed securities, from a wider range of depository institutions than before in exchange for assets or reserves. This policy allowed depository institutions to swap risky assets for safer assets or reserves.

• Extension of Deposit Insurance: Deposit insurance was extended to other institutions, such as money market funds. This policy was aimed at preventing runs.

• Troubled Asset Relief Program (TARP): The TARP was conducted by the U.S. Treasury. The TARP was funded with $700 billion of government debt. Under it, the U.S. government took direct equity stakes in major depository institutions. This action directly increased these firms’ equity and reserves. In December of 2008 some of the TARP funds were used to assist major automakers.

The At Issue detail presents arguments within the Fed for and against keeping interest rates low. Janet Yellen, the past chair of the Fed, presents arguments in favor of this policy and two other Fed president argue against it.

Macroprudential Regulation Macroprudential regulation is financial regulation to lower the risk that the financial system will crash.

• •

The global financial crisis of 2007–2008 brought this type of regulation to center stage.

Glass–Steagall: The U.S. Banking Act, 1933—the Glass–Steagall Act—was an early example of macroprudential regulation. To lower the risk of bank failure, the Act required the separation of commercial banking and investment banking. This Act was repealed in 1999 and mega-banks that did not separate commercial and investment activities emerged. .

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Dodd–Frank: The Dodd–Frank Wall Street Reform and Consumer Protection Act, 2010, also known as the Financial Stability Act of 2010, or as Dodd–Frank, created the Financial Stability Oversight Council (FSOC) and made wide-ranging changes in financial regulation. Its two highlights are • The Volcker Rule: The Volker Rule (proposed by Paul Volker, a former Fed Chairman) is a restriction similar to the prohibition of combined investment and commercial banking in the Glass–Steagall Act. The rule restricts the amount that a banks may invest in hedge funds and private equity funds to a maximum of 3 percent of their capital.

• Orderly Liquidation Authority: Dodd-Frank established the Orderly Liquidation Authority, which empowers the FOSC to determine that the liquidation of a financial institution is necessary for the stability of the financial system.

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Additional Problems 1.

In Freezone, shown in Figure 14.1, the aggregate demand curve is AD, potential GDP is $300 billion, and the short-run aggregate supply curve is SASB. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

2.

Suppose that in Freezone, shown in problem 1, the short-run aggregate supply curve is SASA and a drought decreases potential GDP to $250 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why?

3.

Figure 14.2 shows the economy of Freezone.

The aggregate demand curve is AD, and the short-run aggregate supply curve is SASA. Potential GDP is $300 billion. a. What are the price level and real GDP? b. Does Freezone have an unemployment problem or an inflation problem? Why? c. What do you predict will happen in Freezone if the central bank takes no monetary policy actions? d. What monetary policy action would you advise the central bank to take and what do you predict will be the effect of that action?

4.

Suppose that in Freezone, shown in problem 3, the short-run aggregate supply curve is SASB and potential GDP increases to $350 billion. a. What happens in Freezone if the central bank lowers the federal funds rate and buys securities on the open market? b. What happens in Freezone if the central bank raises the federal funds rate and sells securities on the open market? c. Do you recommend that the central bank lower or raise the federal funds rate? Why? .

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China Raises Reserve Requirements The People’s Bank of China, the country’s central bank, raised the reserve requirements of its top commercial banks to put a squeeze on the credit market following a spell of robust economic growth.

Source: International Business Times, October 11, 2010 a. If the United States had the economic performance of China, what monetary policy actions would the Fed’s most likely take. b. How would you expect China’s monetary policy of squeezing the credit market to influence aggregate demand in China. Would you expect it to have a multiplier effect? Why or why not? c. What actions might the People’s Bank of China take to slow the economy?

Solutions to Additional Problems 1.

a. b. c.

d.

2.

a.

b.

c.

3.

a. b. c.

d.

The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 110 and real GDP is $400 billion.

Freezone has an inflation problem because its real GDP, $400 billion, is greater than its potential GDP, $300 billion. In this case if no action is taken Freezone will suffer from inflation.

If the central bank takes no monetary policy action, the nominal wage rate and other resource costs will eventually rise so that short-run aggregate supply decreases. Ultimately in the long run the economy will reach equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will rise to 120.

The central bank can take a contractionary monetary policy by raising the interest rate. This policy decreases aggregate demand, which decreases real GDP, lowers the price level, and decreases inflation. Decreasing real GDP, however, will increase the unemployment rate.

Freezone’s price level is 130 and its real GDP is $200 billion. Freezone has an unemployment problem because its real GDP is less than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand will increase. The increase in aggregate demand will raise the price level and increase real GDP, helping solve Freezone’s unemployment problem.

If the central bank raises the federal funds rate and sells securities, aggregate demand decreases.

As a result, the price level falls and real GDP decreases, which worsens Freezone’s unemployment problem.

Freezone should lower the interest rate and buy securities because this policy will help solve Freezone’s unemployment problem.

The price level and real GDP are determined at the intersection of the aggregate demand curve and short-run aggregate supply curve. The price level is 130 and real GDP is $200 billion.

Freezone has an unemployment problem because its real GDP, $200 billion, is less than its potential GDP, $300 billion.

If the central bank takes no action, the nominal wage rate and other resource costs eventually fall so that the short-run aggregate supply increases. Ultimately in the long run the economy will reach an equilibrium with real GDP equal to potential GDP, $300 billion, and the price level will fall to 120.

The central bank can take an expansionary monetary policy by lowering the interest rate. This policy increases aggregate demand, which raises the price level and increases real GDP. Unemployment decreases. Raising the price level, however, increases the inflation rate.

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a.

b.

c.

5.

a.

b.

c.

Freezone’s price level is 110 and its real GDP is $400 billion. Freezone has an inflation problem because its real GDP is greater than its potential GDP. If the central bank lowers the federal funds rate and buys securities, aggregate demand increases. The increase in aggregate demand increases real GDP and further raises the price level, worsening Freezone’s inflation problem.

If the central bank raises the federal funds rate and sells securities, aggregate demand decreases.

As a result, real GDP decreases and the price level falls, which will decrease inflation and help solve Freezone’s inflation problem.

Freezone should raise the federal funds rate and sell securities because this policy will help solve Freezone’s inflation problem.

The Fed most likely would undertake contractionary monetary policy, as did the People’s Bank of China. The Fed, however, would probably raise the federal funds rate rather than raise reserve requirements.

China’s policy is designed to decrease the supply of loanable funds in China, thereby raising the real interest rate in China and decreasing investment and consumption expenditure. Aggregate demand decreases because both consumption expenditure and investment decrease. The overall impact of this policy might be smaller than expected because foreign loanable funds will flow into China to take advantage of the higher Chinese real interest rate. This increase in the supply of loanable funds will moderate the rise the interest rate. Even so, it is likely there will be a small multiplier effect if aggregate demand decreases because there will be some induced decrease in consumption expenditure.

The People’s Bank of China could raise the Chinese interest rate or, as it has done, increase reserve requirements.

Additional Discussion Questions 1.

Suppose events in the rest of the world cause the exchange rate to fall when the U.S. economy is at full employment. How should the Fed react in order to maintain macroeconomic stability? Why? The fall in the foreign exchange rate increases U.S. aggregate demand and will, if left alone, create an inflationary gap. The Fed should conduct a contractionary monetary policy by raising the federal funds rate. The contractionary monetary policy decreases U.S. aggregate demand and offsets the incipient inflationary gap.

2.

What limits the Fed’s ability to steer the economy to avoid both recession and inflation?

The Fed can offset fluctuations in aggregate demand because its monetary policy affects aggregate demand. So, for instance, if aggregate demand decreases the Fed can undertake expansionary monetary policy to increase aggregate demand, thereby offsetting the original decrease. However the Fed cannot offset fluctuations in aggregate supply without either creating more inflation or more unemployment. For instance, if aggregate supply decreases, the price level rises and real GDP decreases. If the Fed combats the higher price level (and rise in inflation) by using contractionary monetary policy, real GDP decreases even more.

And if the Fed combats the decrease in real GDP (and rise in unemployment) by using expansionary monetary policy, the price level rises still higher.

3.

Why is there a difference between the short-run and long-run effects from an increase in the quantity of money? In the short run the price level rises and the money wage rate does not change, so the economy moves along its short-run aggregate supply curve and real GDP increases. Real GDP can be different from potential GDP. But in the long run the money wage rate rises to adjust to the rise in price level. Once this adjustment takes place, real GDP

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returns to potential GDP. When that occurs in the long run, the effect of the increase in the quantity of money has worn off.

4.

What are the benefits of using rules to conduct monetary policy? Rules have one major benefit: People can understand them. The point is that members of the economy need to make decisions about what to supply and what to demand. On average these decisions will be better the less uncertainty faced. One source of uncertainty is monetary policy. If monetary policy is erratic and takes people by surprise they will often find that they have made sub-optimal decisions that they regret. If monetary policy follows rules—especially easily followed and easily understood rules—then this source of uncertainty is removed from people’s calculations. As a result, following rules will help members of the public make better economic decisions which means the economy will function better.

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Flexibility

HOW TO ASSEMBLE YOUR COURSE

Introduction Instructors who have already used Michael Parkin’s Macroeconomics are aware of its flexibility: There are many ways to teach from this book, depending on your preferences. Because there is no necessarily right or wrong way to teach a principles of macroeconomics class, the macroeconomic part can be used in a variety of ways. The most obvious one is the order in which the chapters are printed. Others are summarized below.

Macroeconomics At both the professional and the principles level, macroeconomics is unsettled: Economists range from Keynesian to monetarist to rational expectations new classicalists to new Keynesians to real business cycle advocates. Instructors disagree whether to teach economic growth or business cycles first. My text recognizes these perspectives and provides a vehicle through which you can place the approach on your choosing on your course. It is possible to teach a course that emphasizes a Keynesian perspective or one that takes a monetarist point of view. If you want to teach economic growth before business cycles, you can do so; if you want to cover business cycles first, you are equally free to do so. You can adapt the macroeconomic chapters to be the type of course you want and still be assured of a high quality of presentation.

Table 1 presents all the chapters. It shows the two necessary foundation chapters and then the large array of chapters that you can cover next. It also shows the necessary pre-requisite chapters for the concluding three final chapters. Table 1 illustrates how you can emphasize precisely the points you think most important. The choice is up to you because you can shape the course you want to teach.

.

x

HOW TO ASSEMBLE YOUR COURSE

Table 1

.

P r e f a c e

Introduction At no time in history has teaching the principles of economics been either more challenging or more important. Your decision to adopt the thirteenth edition of my textbook brings to your task a set of teaching and learning tools that are unmatched in their clarity, relevance, and currency. It is my hope that with the help of these tools, you will enable your students to become as excited about economics as you are.

Whether you’re teaching the principles course for the first time or are an experienced teacher at this level, I hope you will find this manual helpful.

Each chapter in the manual consists of five parts: 1. The Big Picture: This part provides a discussion of “Where we are going” and “Where we have been.” In other words it helps you fit this particular chapter into the context of what has come before and what will come later. This Big Picture information can help you provide the Big Picture to your students.

2. New in the Thirteenth Edition: Both the major and the minor changes in this thirteenth edition of the textbook are described in this section. The changes noted are especially those that might affect your lecture, so if you are an experienced Parkin user, glance at these to see what’s different in this edition of the textbook.

3. Lecture Notes: We have created a set of ready-to-use lecture notes for each chapter. You will be able to glance over these notes before class, take them into class, and deliver from them your polished lecture. These notes have been heavily revised from the last edition to reflect all the latest changes.

These notes provide: • Concise (bullet point) statements of all the key material • Tables and figures that differ from those in the book so that you can use new examples in your lectures • Key terms in bold print and the definitions from the textbook so that you can be sure that you don’t confuse your students by defining a term differently than the book • Highlighted boxes with teaching suggestions that reinforce a key concept, provide an additional anecdote, or suggest how to handle a difficult idea 4. Additional Problems: We present some additional problems that reflect the problems in the textbook. Some of these problems are carried over from the previous edition’s Solutions Manual; others are new for this edition. Solutions for all the additional problems are provided.

5. Additional Discussion Questions: Additional discussion questions have been created for each chapter. Some of these questions are suitable for essay exams; others, more open-ended, are probably best used for classroom discussion. All of them are designed to make your students think and use the material you have been teaching them.

Do not forget that the answers and solutions to all the Review Quizzes and the Problems at the end of each chapter are provided in a separate book, the Solutions Manual. The Solutions Manual has both the questions from the textbook and complete answers all in one handy source. You can use these answers .

iv

PREFACE

and solutions to help you grade problems you have assigned to the students or else you can copy them and hand them out directly to the students.

The Electronic Classroom The next Perspective features a special essay designed to assist your teaching in another way by discussing MyEconLab, an incredibly powerful Internet site that is a source of “one-stop shopping” for both your students and you. This essay can help you see all that is available to you—and your students!— on MyEconLab.

Acknowledgments Teaching the principles of economics is a “work in progress.” As new insights are uncovered, as new knowledge emerges, the principles of economics course changes and evolves. So, too, are Parkin’s Microeconomics and Macroeconomics always changing and evolving to remain the best books available for you and your students’ use. Thus, it is with a great deal of pleasure that we acknowledge and thank several people who have helped us in shaping this edition of the Instructor’s Manual.

Mark Rush of the University of Florida edited (slightly!) the very fine work of Russ McCullough of Ottawa University, who adapted previous work and wrote the new material for this, the thirteenth edition of this instructor’s manual for Parkin’s Macroeconomics.

Even with all this help, there remains room for improvement in the text and (says Mark) in this manual. Any corrections, suggestions, or comments that you have will be greatly appreciated. Send your comments on this manual to Mark (Mark.Rush@cba.ufl.edu) and your comments on the text to me (michael.parkin@uwo.ca).

Michael Parkin University of Western Ontario

.

Flexibility

HOW TO ASSEMBLE YOUR COURSE

Introduction Instructors who have already used Michael Parkin’s Microeconomics are aware of its flexibility: There are many ways to teach from this book, depending on your preferences. Because there is no necessarily right or wrong way to teach a principles of microeconomics class, the microeconomic part of the book can be used in a variety of ways. The most obvious one is the order in which the chapters are printed.

Other paths are illustrated in Table 1.

Microeconomics Table 1 presents the flexibility in the microeconomic chapters. This is organized according to the three basic foundation chapters followed by a large selection of chapters you can next tackle. After finishing some or all of these chapters, more choices are presented. You can move quickly or slowly to the examining production and firms; quickly or slowly to efficiency and government policy in markets; quickly or slowly to consumer choice. The choice is up to you because you can shape the course you want to teach.

.

x

HOW TO ASSEMBLE YOUR COURSE

Table 1

.

P r e f a c e

Introduction At no time in history has teaching the principles of economics been either more challenging or more important. Your decision to adopt the thirteenth edition of my textbook brings to your task a set of teaching and learning tools that are unmatched in their clarity, relevance, and currency. It is my hope that with the help of these tools, you will enable your students to become as excited about economics as you are.

Whether you’re teaching the principles course for the first time or are an experienced teacher at this level, I hope you will find this manual helpful.

Each chapter in the manual consists of five parts: 1. The Big Picture: This part provides a discussion of “Where we are going” and “Where we have been.” In other words it helps you fit this particular chapter into the context of what has come before and what will come later. This Big Picture information can help you provide the Big Picture to your students.

2. New in the Thirteenth Edition: Both the major and the minor changes in this thirteenth edition of the textbook are described in this section. The changes noted are especially those that might affect your lecture, so if you are an experienced Parkin user, glance at these to see what’s different in this edition of the textbook.

3. Lecture Notes: We have created a set of ready-to-use lecture notes for each chapter. You will be able to glance over these notes before class, take them into class, and deliver from them your polished lecture. These notes have been heavily revised from the last edition to reflect all the latest changes.

These notes provide: • Concise (bullet point) statements of all the key material • Tables and figures that differ from those in the book so that you can use new examples in your lectures • Key terms in bold print and the definitions from the textbook so that you can be sure that you don’t confuse your students by defining a term differently than the book • Highlighted boxes with teaching suggestions that reinforce a key concept, provide an additional anecdote, or suggest how to handle a difficult idea 4. Additional Problems: We present some additional problems that reflect the problems in the textbook. Some of these problems are carried over from the previous edition’s Solutions Manual; others are new for this edition. Solutions for all the additional problems are provided.

5. Additional Discussion Questions: Additional discussion questions have been created for each chapter. Some of these questions are suitable for essay exams; others, more open-ended, are probably best used for classroom discussion. All of them are designed to make your students think and use the material you have been teaching them.

Do not forget that the answers and solutions to all the Review Quizzes and the Problems at the end of each chapter are provided in a separate book, the Solutions Manual. The Solutions Manual has both the questions from the textbook and complete answers all in one handy source. You can use these answers .

iv

PREFACE

and solutions to help you grade problems you have assigned to the students or else you can copy them and hand them out directly to the students.

The Electronic Classroom The next Perspective features a special essay designed to assist your teaching in another way by discussing MyEconLab, an incredibly powerful Internet site that is a source of “one-stop shopping” for both your students and you. This essay can help you see all that is available to you—and your students!— on MyEconLab.

Acknowledgments Teaching the principles of economics is a “work in progress.” As new insights are uncovered, as new knowledge emerges, the principles of economics course changes and evolves. So, too, are Parkin’s Microeconomics and Macroeconomics always changing and evolving to remain the best books available for you and your students’ use. Thus, it is with a great deal of pleasure that we acknowledge and thank several people who have helped us in shaping this edition of the Instructor’s Manual.

Mark Rush of the University of Florida edited (slightly!) the very fine work of Laura Wolff of Southern Illinois University Edwardsville, who adapted previous work and wrote the new material for this, the thirteenth edition of this instructor’s manual for Parkin’s Microeconomics..

Even with all this help, there remains room for improvement in the text and (says Mark) in this manual. Any corrections, suggestions, or comments that you have will be greatly appreciated. Send your comments on this manual to Mark (Mark.Rush@cba.ufl.edu) and your comments on the text to me (michael.parkin@uwo.ca).

Michael Parkin University of Western Ontario

.